The Law and Economics of Contract Interpretation

Contract interpretation is an understudied topic in the economic analysis of contract law. This Article combines simple formal analysis of the tradeoffs involved in interpretation with applications to the principal doctrines of contract interpretation, including the "four corners " rule, mutual mistake, contra proferentum, and what I call the (informal but very important) rule of "extrinsic nonevidence." Gap filling is distinguished, and the relativity of interpretive doctrines to the interpretive medium-jurors, arbitrators, and judges in different kinds of judicial systems-is emphasized. I. Introduction There is now a large economic literature on contracts and contract law, but the interpretation of contracts, as distinct from issues involving formation, defenses, validity, and remedies, has been rather neglected. Not entirely so;1 but the economic literature on contract interpretation has an abstract cast, evincing only limited interest in the relevant legal doctrines.2 Interpretation might seem an activity remote from economics-a subject for cognitive psychologists, epistemologists, students of linguistics, legal doctrinalists, perhaps even literary critics, rather than for economically minded lawyers-but I shall try to show that economics can be of considerable help in understanding the problems involved in interpreting contracts. Contract interpretation is the undertaking by a judge or jury (or an arbitrator-more on arbitration later) to figure out what the terms of a contract are, or should be understood to be.3 It should be distinguished from simple enforcement. The most important function of contract law is to provide a legal remedy for breach in order to enhance the utility of contracting as a method of organizing economic activity,4 and that function is independent of whether there is any uncertainty about the meaning of terms. The defendant may challenge the plaintiff's interpretation of the contract rather than acknowledge the breach, but unless there is a real uncertainty about meaning, the challenge will present no interesting question of interpretation. Still, significant interpretive questions often arise in contract litigation. The obvious but not the only reason, besides clumsiness in the use of words, against which the legal linguists warn us,5 is that contractual performance generally occurs over time rather than being complete at the instant the contract is signed. This is a central rather than an accidental feature of the institution of contract. Were exchange simultaneous and limited to goods the quality of which was obvious on inspection, so that there was no danger of unwanted surprises, there would be little need either for contracts or for legal remedies for breach of contract. The main purpose of contracts is to enable performance to unfold over time without either party being at the mercy of the other, as would be the case if, for example, a buyer could refuse to pay for a custom-built house for which there were no alternative buyers at or above the agreed price. So contracts regulate the future, and interpretive problems are bound to arise simply because the future is unpredictable.6 Stated otherwise, perfect foresight is infinitely costly, so that, as the economic literature on contract interpretation emphasizes, the costs of foreseeing and providing for every possible contingency that may affect the costs of performance to either party over the life of the contract are prohibitive.7 Even in a setting of perfect foresight, an interpretive problem may arise. Parties may rationally decide not to provide for a contingency, preferring to economize on negotiation costs by delegating completion of the contract to the courts should the contingency materialize. This is especially likely if they think there is only a slight probability that the contingency will materialize. But even if they think the probability significant, they may prefer not to provide for the contingency. …