Revisiting the Contracts Scholarship of Stewart Macaulay, Post V: Gillian Hadfield

This is the fifth in a series of posts in our online symposium on the Contracts Scholarship of Stewart Macaulay.  More about the online symposium can be found here.  More information about this week’s guest bloggers can be found here. 

Gillian K. Hadfield is the Richard L. and Antoinette Schamoi Kirtland professor of law and professor of economics at the University of Southern California. 

Maybe Contract Law Isn’t Dead After All

In 1963 Stewart Macaulay asked:  what good is contract law?  His interviews with business(men) in a rangeof companies—including giants like General Electric, S.C. Johnson and Harley-Davidson—suggestedthe answer was “not much.”  He wasrepeatedly told that in practice, formal contracts were rarely drawn up fortransactions (and that the boilerplate purchase orders and acknowledgementsthat might be exchanged weren’t really even seen as “contracts”.)  Any formal contracts that did come intoexistence were largely ignored, almost never pulled out of the drawer to helpresolve transactional problems that might occur along the way.  And the idea of litigating, or eventhreatening to litigate, to resolve a dispute was dismissed almostentirely.  

A dramatic set of findings. They earned Stewart (pictured), in Grant Gilmore’s famous formulation, the title of“Lord High Executioner” of contract law, sounding the death knell of lawyers’taken-for-granted assumption that they were essential to doing business.  Economists—introduced to the article fifteenyears after it was published in two of the seminal papers in transaction costeconomics, Klein,Crawford and Alchian (1978) and Williamson(1979)—were energized.  A great floodof work, much of it game-theoretic, soon followed to explain the puzzle of howbusiness deals were held together without law. Soon we had a standard distinction in the economics literature:  between formal—court-enforceable—contractsand informal ones—those enforced only by threats of the loss of a valuablelong-term relationship or reputational standing.

Given how important Macaulay’s work has been to economists,my co-author Iva Bozovic and Iwere surprised to find out that almost no-one has attempted to replicateStewart’s self-styled “preliminary study.” So we decided to try.  So much hadchanged in industry since the early 1960s when Stewart did his research (MadMen anyone?) we wondered whether contract law still was as irrelevant tocontracting as it seemed to be back then. We were particularly interested in the impact of a much moreinnovation-oriented economy on contracting. And it was hard to predict how Macaulay’s findings might carryover.  On the one hand, in relationshipsthat are focused on innovation—think collaboration between Facebook and Skypeto integrate video chat and social networking, for example—so much is changingso rapidly that often the parties don’t have much of a clue how theirrelationship is going to develop.  Thatimplies it’s really hard to write complete contracts that can be easilyenforced in court.  On the other hand,there is so much novelty that there is almost no time for industry standards tostabilize giving parties guidance about how gaps in contracts are to be filledin.  This is a part of Macaulay’sfindings often overlooked among economists (although it is dear to the heart oflaw and society folks):  in Macaulay’sstudy, the parties didn’t need well-drafted contracts because they hadwell-established industry norms to look to for guidance on how problems shouldbe dealt with.  Breach of those norms wasbad for business in a stable environment with lots of alternative contractingpartners. 

So if parties to high-velocity innovative businessrelationships don’t have established industry norms to look to and it’s so hardto write relatively complete court-enforceable contracts, what do they do? 

We set out to study this question byinterviewing companies in the San Francisco Bay Area and Los Angeles abouttheir use of contracts.  We first askedour respondents—all of whom were senior level executives, almost all of whomwere not lawyers—whether they considered their business to be innovative in anyway.  Perhaps surprisingly, in ourinitial random sample of firms, many answered “no”.  We then supplemented our sample with firms wewere pretty sure were innovative. In the end we spoke with 30 companies—12 whoidentified as ‘not innovative’ and 18 who identified as ‘innovative.’  We asked the innovators to talk to us about arelationship with another firm that was important to them for innovation.  We asked the non-innovators to talk to usabout a relationship with another firm that was important to them for businesssuccess. 

Here’s what we found out. The non-innovators told us essentially what Macaulay’s respondents toldhim:  we don’t draft formal contracts, weignore any that do get drafted, and we never look to litigation as a threat orsource of enforcement.  The fascinatingtwist was from the innovators; only one of Macaulay’s findings held up.  Yes, we spend a lot of time and lawyer moneyon drafting formal contracts.  Yes, wehaul the contracts out of the drawer to consult when trying to resolvetransactional problems along the way. BUT:  no, we never look tolitigation as a threat or source of enforcement.  This isn’t because they settle their disputesin the shadow of the law.  It is becausea litigation threat is just not credible: it’s too expensive, takes too long, is too unpredictable and killsprecious reputation. 

Our sample, like Macaulay’s “preliminary study,” issmall.  It’s not necessarily representative.  But, like Macaulay, we have unearthed afascinating puzzle:  why draft andconsult formal contracts if you have no expectation of ever enforcing contractsin court?  According to the relationalcontracting literature that economists produced in response to Macaulay’s puzzle(if not contract, then what?), the only reason to write a formal contract is toget the benefit of formal court enforcement. 

Our answer, drawing on work I’ve done with Barry Weingast (seehere and here) about the function oflaw, is that formal contracting serves to coordinate beliefs about what constitutesa breach of a highly ambiguous set of obligations.  This makes relational enforcementmechanisms—loss of a valuable relationship, bad reputation—more effective thanthey would have been in the absence of a shared template for interpretingevents.  We call this scaffolding:  formal contract law and reasoning—implementedby lawyers who share similar interpretation methods and materials that arecommon knowledge among them—helps to span the (large) gaps in relationalmechanisms that arise when ambiguity is high. It’s not that formal legal reasoning from a formal contract to decidewhether a contracting partner is in “breach” is open-and-shut in thesesettings—there’s still lots of ambiguity to go around.  But our point is that the extent of ambiguitywhen the parties have at least designated a common methodology for classifyingconduct as breach or not is much less than it would be otherwise.  We think the reason law gets singled out toplay this role is because it is, as my work with Weingast emphasizes, expresslydesigned to perform this kind of an ambiguity-reducing and coordinatingrole—with its emphasis on comprehensive coverage, clarity and the presence ofan authoritative steward (eg. courts) that is recognized as the final word oninterpretation. 

Our paper (which we wanted to work on more after theconference so it does not appear in the book whose publication this Symposiumcelebrates) provides lots of quotes from the businesspeople with whom we talkedto support our analysis.  It’s hardly thelast word on the subject—there’s that “preliminary” again—but it moves ourunderstanding of the role of contract law a little further down the field onwhich Stewart first called the game—what good is contract law?  Our answer: quite a bit actually, even ifalmost nobody plans on going to court.  

[Posted, on Gillian Hadfield’s behalf, by JT]