Anticipating Litigation in Contract Design

Contract theory does not address the question of how parties design contracts under the existing adversarial system, which relies on the parties to establish relevant facts indirectly by the use of evidentiary proxies. In this Article, we advance a theory of contract design in a world of costly litigation. We examine the efficiency of investment at the front end and back end of the contracting process, where we focus on litigation as the back-end stage. In deciding whether to express their obligations in precise or vague terms, contracting parties implicitly allocate costs between the front and back end. When the parties agree to vague terms (or standards), such as best efforts or commercial reasonableness, they delegate to the back end the task of selecting proxies: For example, the court selects market indicators that serve as benchmarks for performance. When the parties agree to precise terms (or rules), they invest more at the front end to specify proxies in their contract, thereby leaving a smaller task for the enforcing court. We explore the choice between rules and standards in terms of this tradeoff, and we offer an explanation for why contracts in practice have a mix of vague and precise provisions. We then suggest that parties can achieve further contracting gains by varying the procedural rules that will govern their disputes in court. We illustrate by examining provisions in commercial contracts that allocate burdens and standards of proof. If the parties can improve the cost-effectiveness of litigation in this manner, they can further lower contracting costs by shifting more investment to the back end through their increased use of vague terms. Although vague terms have fallen into disfavor with contract theorists, this Article offers a justification for their frequent use in commercial practice