An Evolutionary Perspective on Contracting: Evidence from Poison Pills

The law and economics literature on contract theory widely recognizes that contracts are costly to write and therefore are incomplete. As a result, contracts cannot cover all future contingencies, opening parties up to ex post opportunism and renegotiation. These problems posed by contractual incompleteness and the economic arrangements parties design to cope with them is a major research area in law and economics, especially in the theory of the firm. The overall upshot of contractual incompleteness is that parties design economic solutions to deal the problem of underinvestment that incomplete contracts create. The economic institutions hypothesized in this literature, however, are not the only responses to the problem of transaction costs and resulting incomplete contracts. Contract drafters have their own legal responses to economize on the costs of foreseeing all contingencies and writing terms to deal with them. Most importantly, contract drafters use a precedent document as a template in virtually all major transactions as a heuristic to reduce the costs of foreseeing all contingencies and drafting provisions to deal with them. The use of precedent documents is a rational response to the prohibitive costs of drafting complete contracts from scratch. However, precedent-based drafting itself inherits a transaction cost problem, because there are costs associated with understanding the purposes and implications of the terms contained in precedent documents. As a result, terms from precedent documents are copied, modified, and recopied, sometimes indiscriminately. A growing empirical literature has documented this problem, suggesting that contracts are path dependent, varying not only according to the needs of a particular transaction but also according to the line of descent the contract language followed. Thus, while the economic theory envisions contracts with (incomplete) provisions rationally adapted to conscious ends, the path dependency literature sees both incompleteness and vestigial terms, with “drift” rather than “design” as the driver of much of the change in transactional legal documents. The copying, editing, and recopying of transactional text suggests a biological analogy drawn from molecular evolution. A process very similar to the copying, editing, and recopying occurs in the process of propagation of genetic information. Like the legal setting, the variation in DNA over time is partly the result of selection and partly the result of “drift,” and a parallel debate exists over the relative extent of the sources of variation. This paper presents evidence that contract provisions “evolve” in a manner much like that biological genetic sequences, in a process that is at least partly one of drift. This paper illustrates this process of “genetic” drift in the text of transactional legal documents by exploiting a unique observational setting—stockholder rights agreements (or “poison pills”). Because the poison pill was created at a specific point in time in the recent past, its descent can be traced from the very first ancestor to the present versions, allowing clear illustration of the process of change over time. Using a computer analysis of the terms of all extant poison pills, this paper reconstructs a “phylogenetic” tree of all extant poison pills showing the ancestry of each document. The preliminary results suggest most changes in the text of transactional documents do not rapidly respond to exogenous shocks or merely passage of time, but instead drift directly in proportion to generations elapsed since the ancestral document. This paper is only a preliminary exploration of an evolutionary metaphor for contract language, but suggests a number of potential avenues for research. In particular, a model of the “mutations” or changes in legal language is necessary to increase the resolution of this analysis. Such a model will allow a better understanding of how legal provisions change over time, the effects that those changes create, and perhaps increase the quality of judicial interpretation of gaps and ambiguous contract provisions.