Legal Theory Lexicon: Default Rules and Complete Contracts
Introduction
At some point in the introductory class in contract law, students
are likely to encounter a very powerful idea–the distinction between
"default rules" and "mandatory rules." The basic distinction is easy
to grasp. Some rules of contract law supply default terms that are
subject to contractual override; other rules of contract law are
mandatory–they can’t be modified by the contract. Lurking in the
background of this distinction is a theoretical construct–the complete
contract, an idealized contract that would include explicit terms
covering every possible contingency. Once you understand the
distinction between default rules and mandatory rules, additional
questions arise: as a matter of normative contract theory, which rules
should be default rules and which rules should be mandatory? And what
normative principles should guide the design of default rules?
As always, this post in the "Legal Theory Lexicon" series is aimed
at law students–especially first year law students–with an interest
in legal theory.
Default Rules and Mandatory Rules
Let’s start with the "takeaway" point. In contract law, we can sort
the rules into two sorts, "default rules" and "mandatory rules."
Here’s an example. The Uniform Commercial Code (or UCC, the
codified law of contract that applies to contracts between businesses
as a matter of state law in the United States) creates a duty to act in
good faith–this is a mandatory rule, because this duty cannot be
disclaimed by a contractual provision. The UCC also includes an
implied "warranty of merchantability," that attaches to contracts, but
can be waived by agreement–this is a default rule.
Grasping this distinction is important for at least two reasons.
First, unless you know whether a given rule of contract law is a
default rule or a mandatory rule, you don’t really know the law. And
it isn’t always clear whether a given rule is one or the other: the
usual tipoff is language like, "unless the contract provides otherwise"
or "absent an agreement to the contrary." Second, the distinction
between default rules and mandatory rules is fundamental to the
normative structure of contract law. Learning contract is more than a
matter of mastering the rules; mastering the arguments of principle and
policy that can be used to argue for and against the rules is equally
important. But the arguments for default rules and the arguments for
mandatory rules must be different–because these two kinds of rules
have different functions.
Generalizing the Idea of "Default Rule"
Although the notion of a "default rule" is usually introduced to law
students in the context of contract law, the idea is more general. For
example, we could think of the law of wills and intestate succession
through this theoretical lens. Rules of intestate succession are
"default rules" that can be overridden by a will. Much of the law of
wills consists of default rules, and we can imagine a "complete will"
that covered every possible contingency.
Similarly, we can imagine a "complete code" that covers every
possible action or inaction and specifies what legal consequences
follow. Given that actual codes are incomplete, we can look at the law
of statutory interpretation as including a collection of "default
rules" that allow courts to fill in the gaps. Another example is
provided by corporations law–once again, some of the rules are
mandatory and others are merely defaults.
You get the idea–default rules can be applied to any authoritative legal text that is "incomplete."
Normative Theories of Default Rules
Once we understand the distinction between default rules and
mandatory rules, we can then ask the question, "What normative
principles should guide the design of default rules?" For example, we
might decide that lawmakers (legislators or common-law judges) should
attempt to devise the default rules that are most likely to be the
rules that the parties would have adopted had they contracted on the
issue. Or we might want "efficient" default rules. Or default rules
that maximize utility. All of these approaches are associated with
normative law and economics. But there are other approaches as well.
For example, we might try to design default rules so that they maximize
the autonomy or liberty of the parties to the contract–imposing the
fewest possible restrictions that have not actually be agreed to by the
parties. Or we might impose default rules that will serve some other
goal such as distributive justice or economic equality.
Default Rules as Public Goods
Another interesting question is why the law provides default rules
at all. Why don’t we force the parties to reach complete agreements?
Immediately, of course, we realize that this would be very costly.
Drafting a complete contract would almost always (perhaps always) cost
more than the contract is worth. And there is another problem as
well. Most contract provisions are not protectable as intellectual
property; in general, you can’t copyright or patent a nifty contractual
provision. (You may be able to copyright the specific language, but
that doesn’t preclude someone else from expressing the idea in
different language.)
This suggests an interesting perspective on the economics of default
rules. We might see the default rule provisions of contract law as a
"public good." That is, consumption of default rules is
"nonrivalrous"–because my use of a given provision doesn’t interfere
with your ability to use the same provision. And consumption of
default rules is "nonexcludable"–assuming that there is no
intellectual property protection available for "form contracts" or
"form contract provisions." If this is correct (and it may not be),
then there is a classic economic justification for government to
provide for the "public good." For more on the idea of a public good,
see Legal Theory Lexicon 029: Public and Private Goods.
Complete Contracts
Now that we have the basic distinction between default and mandatory
rules in mind, let’s discuss the related idea of a complete contract.
Once again, the core intuitive idea is relatively simple–a complete
contract has provisions that cover "every contingency." In other
words, a complete contract has no gaps.
Why did I put "every contingency" in scare quotes? Because "every
contingency" is an ambiguous way of formulating a fairly complex idea.
We need some special terminology here. Economists tend to use the
phrase "states of affairs" to express the idea of a contingency. A
"state of affairs" is simply a way that the world can be–a complete
specification of the way things are. Philosophers use different
jargon–the phrase "possible world" expresses the same idea as "state
of affairs."
So a truly "complete" contract would be a contract that specified
the duties and rights of the parties for all the future states of the
world–or all the possible worlds that share the history of the actual
world up to the point the contract is formed. Once you think about it,
it becomes clear that no actual contract could be complete. There are
infinitely many possible future states of the world–and a contract
that covered all of them would have an infinite number of provisions,
and hence the drafting of such a contract would never be complete–it
would still be unfinished when the universe reached a state of complete
entropy. (Oh, and by the way, that’s one of the contingencies that the
contract would have to cover.)
So the notion of a complete contract is an idealization–not a
practical option. And once we see this point, another point becomes
obvious. Contract law cannot provide default rules to cover every
possible contingency either. Of course, as a practical matter,
contract law doesn’t have to cover all the contingencies. Some
possible future states of the world are so remote or far-fetched that
they can safely be disregarded–Martian invasions and or the discovery
of a universal fabrication machine are not contingencies about which we
need worry.
The General Idea of Completeness
Just as the idea of a default rule can be generalized beyond
contract law, so can the idea of completeness. So we can imagine
"complete wills," "complete corporate charters," "complete trusts," and
so forth. One particularly important idealization is the idea of a
"complete code"–a legal code that itself has provisions that cover
every possible contingency. The complete code will have default rules
or mandatory rules that for every possible future state of affairs.
Conclusion
Well, as is usually the case, we’ve barely scratched the surface.
Nonetheless, I hope this Lexicon entry has given you a basic framework
for understanding the ideas of a complete contract and the distinction
between default rules and mandatory rules. Once you have this ideas in
your conceptual toolkit, you are likely to start noticing them in all
kinds of contexts, not just in contract law, but in every legal subject
you encounter. When you do, you might ask yourself, "Why is this a
default rule rather than a mandatory rule?," or vice versa. And, "What
normative legal theory or principle supports this choice?"
Links
Complete Contract on Wikipedia
Ian Ayers, Default Rules for Incomplete Contracts
The Desert and the Jungle: Alan Schwartz and Robert Scott on Contract Theory
(This entry was last updated on November 17, 2008.)
Source: Lawrence Solum
