Módulo Docente-Metodológico

The model of cooperation described in Chapter 2 focuses on nonlegal mecha-nisms of cooperation. It suggests that in a variety of circumstances people can cooperate without the intervention of the legal system. But if people can co-operate in the absence of a legal system, then what does the legal system do?

Does it interfere with their ability to cooperate, or does it enhance their ability to cooperate, or does it have some other effect?

Chapters 4 through 8 suggested that the legal system will sometimes en-hance cooperation and sometimes interfere with it. When powerful nonlegal mechanisms of regulation exist, the state is tempted to channel them. The state subsidizes charitable organizations, in order to stimulate public giving, and protects private transfers of wealth but forbids destructive dowry compe-titions. It uses shaming penalties to stimulate the mob against criminals, then conceals punishments and criminal records in order to restrain the mob. It formalizes the marriage vow and defers to household discipline, while regulat-ing the dissolution of marriage in minute detail. It uses propaganda to stimu-late patriotic and nationalist sentiments, but punishes those who discriminate against traditional racial or ethnic antagonists who are included in the “na-tion”—in this way government officials seem to try to define the insiders and the outsiders in the “optimal” way (whatever that is), then hope that the dy-namics of signaling and cooperation will take over, creating mass enthusiasm that makes the standard tools of state coercion unnecessary.

This chapter carries on this theme but approaches the problem in a differ-ent way. Now I focus on commercial behavior, a topic glanced at in Chapters 1, 2, and 4. Those chapters noted that merchants must cooperate with each

other in order to make profits, but cooperation is hampered as always by in-centives to cheat. The long history of commercial behavior is powerful evi-dence that merchants can overcome these incentives much of the time—

enough of the time, anyway, to be able to prosper—despite the absence of le-gal intervention. Examples include the Lombard and Jewish bankers in the early modern period, the Maghribi traders, the Genoese and the Venetians, ethnic Chinese merchants in foreign countries, Korean and other immigrant groups in the United States, and the successful exploitation of common pools by local groups.¹In all of these cases, merchants cooperate and prosper in a lawless environment at the international level, or even in a hostile local legal environment. So one might ask, Why is a state necessary at all for commercial cooperation?

A common answer is that although relatively small and homogenous groups of people can cooperate, citizens of a populous state cannot. But this answer cannot be the whole story. Most people are able to cooperate without resorting to the threat of legal sanctions. In ordinary life, people constantly make and keep promises; and legal retaliation for cheating is never an option because the cost of invoking the law exceeds the amount at stake. The com-mon wisdom might be revised, then, to hold that nonlegal cooperation occurs among people in communities, where information flows freely and reputa-tions are known, but not among strangers.

Even so revised, however, this view is unsatisfactory. What are these con-tracts among strangers? When a consumer purchases a stereo at a retail outlet, the consumer and the “store”—whether we mean the salesclerk, the manager, or the shareholders—are strangers, but it is rare for a consumer to sue the store if the stereo is broken. No rational consumer would sue a store over an object worth a few hundred dollars, when the lawsuit would cost the con-sumer thousands of dollars. But a lawsuit is rarely an issue, anyway; most re-tailers offer warranties and honor them because they fear damage to their reputation. And if the consumer does not honor a promise to pay for the stereo, the retailer might sue the consumer, but more likely it will report him to a credit agency that will record the default on the consumer’s credit report.

So the retailer and the consumer are not really strangers, or if they are, then they embarrass the claim that nonlegal cooperation does not occur among strangers.

Perhaps, then, the “contracts among strangers” refer to arm’s-length sales among merchants. Even here, however, reputation and other nonlegal mecha-nisms play an important role. Most merchants belong to trade associations, clubs, and other organizations, which enable them to meet each other and ex-change information. A large company may have thousands of employees, but all the employees with major responsibilities will attend conventions where

they meet their counterparts in other firms. So what appears to be an arm’s-length contract between two anonymous firms is often the result of negotia-tions between two friends who belong to the same social club or sit on the board of the same charitable organization. An enormous amount of business activity consists of making contacts, or “networking,” and what does this mean if not revealing information about oneself to others, and obtaining in-formation about them in return? Once one has enough inin-formation about someone, then one might trust him enough to do business. Without such information, the paraphernalia of the legal system—the judges, the court-houses, the clerks, the accretion of precedent—are cold comfort.

So when contracts are small, people do not sue each other because it is not worthwhile. When contracts are large, people do not sue each other because they depend on reputation. But if this is so, what is the role of the law? Put differently, if the law were adequate for regulating relations among strangers, then why wouldn’t people rely on the law rather than spending so much time and effort worrying about reputation?

Commercial Behavior

The traditional paradigm of contractual behavior generally assumes that peo-ple make contracts because only legal sanctions will deter a party from cheat-ing on the contract when it is profitable to do so. If each party expected the other to cheat under such conditions, parties would not enter a contract in the first place. The value-maximizing court enforces contracts in such a way that maximizes the ex ante value of the contract, which usually means allocat-ing obligations in a way that places the risk of any contallocat-ingency on the party that can most cheaply bear it and that gives them proper incentives to breach, invest, and engage in related behavior.

This paradigm misdescribes modern commercial practices in many ways. I have mentioned several. Parties to a contract are rarely strangers to each other.

In almost all contracts, one party or both parties care deeply about their repu-tations. In ordinary commercial contracts between merchants, both mer-chants expect to do business with each other in the future, or at least with other merchants who are likely to learn about the behavior of the parties. Em-ployers and workers understand that employment contracts cannot provide for all the behavior that will be required on each side. Workers behave prop-erly in order to obtain bonuses and promotions and in order to avoid being penalized or fired. Employers behave properly in order to maintain the loyalty of their workers and to attract workers entering the market. Even something as transitory as a stock transaction is constrained by nonlegal sanctions. The buyer and seller in the secondary market do not deal with each other. They

both deal with a middleman, the broker, who takes pains to develop a reputa-tion for honesty, and who usually is employed by a firm with a brand name, built up over a number of years.

Other kinds of behavior are hard to explain if one assumes the traditional paradigm. Contracting parties are often friends. A book publisher might take a client out to lunch or dinner. Purchasing agents take suppliers to baseball games, plays and movies, even to strip-tease joints (Meredith 1997). Business deals are everywhere forged in bars, restaurants, and private clubs. Business is almost always conducted in a highly social manner. First, participants talk about sports; then, about their families; and only then, perhaps when the din-ner or golf game is almost over, do they shake hands on the deal.

In the cotton industry, “Merchants take mill buyers on hunting trips just like in any other business . . . In the process, relationships . . . develop[]. Over time a buyer gets the idea that he wants to deal with me not just because of our business relationship, but also because of our personal relationship. So you tell me, when you want to do business who will you call, the guy you like or the guy you don’t like?” (Bernstein 1999, p. 16 (quoting merchant, brack-ets and ellipsis in original)). A major trade association “has sponsored the lo-cal debutante ball, an annual civic cotton carnival, golf tournaments, a Cot-ton Wives Club [sic], a well-known domino tournament, and numerous other civic events. To this day it continues to encourage social interaction among its members and their families by making its annual conventions fam-ily events” (Bernstein 1999, pp. 20–21) Many businesses, trade associations, and other industry groups sponsor social and family events in order to en-hance relationships among their employees or members.

As everyone knows, business is frequently a family matter. The patriarch hires and grooms his children, then transfers ownership to them while he is still alive or upon his death. A husband and wife own and manage a laundry or grocery store, where the children participate as employees. This phenome-non is easy enough to understand. Business based on ethnic relations is harder to understand. People who belong to an ethnic group may know as little about each other as they know about outsiders, yet they are drawn together in common enterprises. A vast number of sociological case studies describe busi-ness relationships that are based on ethnic ties. Only ethnic Koreans are in-vited to participate in the kye, a kind of rotating credit group; and only ethnic Mexicans are invited to participate in the cundida or tanda, their version of the rotating credit group (E. Posner 1996c, pp. 168–71). Many small busi-nesses, particularly in ethnic parts of cities, will hire only co-ethnics, even though these co-ethnics may be no better known to the owners than appli-cants who do not belong to the ethnic group.

If the reliance on ethnicity in business is puzzling, even more puzzling is

the reliance on fictive kinship, where unrelated people treat each other as though they were kin. Commercial “brotherhoods” (or confraternities) from the Middle Ages are familiar, and they survive in the fraternal ideology of la-bor unions. Here is a modern example of fictive family relations in business, described in a strikingly vulgar (and somewhat confused) way:

actually what [franchising] is, is a wedding. Lots of music, lots of flowers, money exchanging hands and lots of kisses. The couple is from the best of two worlds; one of the partners is experienced, with plenty of good know-how, with a proven system; and the other partner is a virgin, who hopefully has never been in business before. The vows they ex-change are almost the same as you exex-changed when you married your wife. The virgin bride must have a burning desire to be “his” own boss and to run “his” own business. (Hadfield 1990, p. 965, quoting Coomer 1970)

Finally, the traditional model puts too big a burden on courts. Many schol-ars acknowledge that courts cannot determine obligations in long-term, “rela-tional” contracts, in which many terms are left out, but appear to believe that courts can determine obligations in shorter, one-shot deals. This latter claim is difficult to confirm or deny, but let me mention two reasons why it is un-likely to be true. First, although the number of unpredictable contingencies that can change the value of a long-term relationship is no doubt huge, the number of unpredictable contingencies that can change the value of one-shot deals is also huge. The fact that the number of contingencies is overwhelming in the first case does not imply that the number of contingencies can be han-dled in the second case. The relatively discrete sale of a house extends over months during which any number of things can happen, only a small fraction of which can adequately be treated in the contract. Short-term contracts al-most always have tails stretching indefinitely in the future. A buyer might sue the seller for a defect in goods discovered months or years after delivery of the product, a suit that requires the court to determine whether intervening con-tingencies are relevant in the determination of obligations.

Second, courts have trouble understanding the simplest of business rela-tionships. This is not surprising. Judges must be generalists, but usually they have narrow backgrounds in a particular field of the law, and they often owe their positions to political connections rather than merit. Their frequent fail-ure to understand transactions is well-documented. One survey of cases in-volving consumer credit, for example, showed that the judges did not even understand the concept of present value (Allen and Staaf 1982). The judges struck down contracts using the unconscionability doctrine because the credit

price was higher than the cash price, but they did not take account of risk and of the time value of money, which were not out of the ordinary. Even when judges do not misunderstand basic ideas, one must take their interpretation of facts on faith. Judges’ reasoning can be evaluated only against the canned facts described in the opinion, which themselves are the result of a fact-finding pro-cess that does not inspire confidence. Given the varying sophistication of trial judges, lawyers, and juries; the accidents of discovery; the unpredictability of witnesses; and the inescapable vagueness of the law, parties could be forgiven for believing that the chance of winning a breach of contract suit is pretty much random. Indeed, skepticism about the quality of judicial decision-mak-ing is reflected in many legal doctrines, includdecision-mak-ing the business judgment rule in corporate law, which restrains courts from second-guessing managers and directors, and the many contract law doctrines that restrain courts from sec-ond-guessing parties to contracts.

These observations suggest the following possibility. Courts are not good at deterring opportunistic behavior in contractual relationships, but parties are.

This is why so much contractual behavior depends on reputation, ethnic and family connections, and other elements of nonlegal regulation, and not on de-tailed and carefully written contracts enforced by disinterested courts. The next section analyzes this hypothesis more formally, and suggests an answer to the question, Why, if they cannot rely on courts to enforce contracts properly, do people so frequently take pains to ensure that their contracts are legally en-forceable?

A Model of Commercial Behavior

Several scholars have noted that contracts are often radically incomplete re-garding the obligations of the parties (Macneil 1978, Goetz and Scott 1981, Hadfield 1990, Schwartz 1992, 1998). Most of these commentators, how-ever, assert that judges can complete the contracts ex post by supplying value-maximizing terms or by enforcing business norms.

Only two commentators have confronted the possibility that judges do not have enough information to allow them to supply appropriate terms when contracts are incomplete. In a mostly positive analysis of judicial response to incomplete contracts, Schwartz (1992) argues that courts adopt either an “ac-tive” or “passive” strategy toward contract disputes. The active strategy is the traditional one of filling gaps in incomplete contracts by constructing the ex ante optimal contract terms. The passive strategy involves literalistic en-forcement of contract terms even though everyone knows that the contin-gency that gave rise to the dispute was not contemplated by the parties when they entered the contract, and so the terms are unlikely to describe optimal

obligations in light of that contingency. Turning from positive to normative, Schwartz argues that courts are competent enough to fill gaps in relatively complete contracts, and they should, for the traditional reasons that appear in the literature. More tentatively, Schwartz suggests that the literalistic ap-proach is suitable for highly incomplete contracts, because gap-filling will fail, and literalistic interpretation at least enables the parties to rely on a set of fixed contractual obligations when renegotiating in light of changed circumstances (see also Schwartz 1998). Schwartz’s argument, however, depends on the as-sumptions that parties can anticipate contingencies with adequate precision, that they can draft sufficiently detailed terms in light of these anticipated con-tingencies, and that courts can enforce these terms accurately. These assump-tions may not be correct and I will relax them.

Hadfield (1994) argues that even incompetent judges should fill gaps in in-complete contracts. If judges’ decisions are inaccurate but better than ran-dom, then their decisions will sometimes punish opportunistic breach and sometimes not. Anticipating this result, the potential breacher will sometimes but not always be deterred from engaging in opportunism, which is a better result than if the potential breacher is never deterred. The existence of judicial error increases the value of the contract to whichever party is in a better posi-tion to breach and reduces the value of the contract to the other party, but the ex post beneficiary must compensate the ex post loser with a lower or higher ex ante contract price. If the judges’ decisions are completely random, no de-terrence will occur, but, as before, an ex ante transfer will compensate the ex post loser, and so the randomness of the judges’ decisions will not affect con-tracting compared to a regime in which no enforcement occurs.²

The problem with Hadfield’s argument is that if one assumes radical judi-cial incompetence, as I do, the system of contract law serves no purpose. Al-though, as she shows, parties do no worse by entering legally enforceable con-tracts than by not entering such concon-tracts, they do not do any better, either.

There is an alternative model for understanding the role of courts when contracts are incomplete. The claim underlying the model is that even if courts cannot determine who breached a contract, or whether a contract has been breached, they can deter opportunistic behavior. This claim might sound implausible, but the key to it is that parties choose when they want to use courts and when they do not, so even an uncomprehending court can serve a purpose as long as it allows itself to be manipulated by the parties.

The model is the cooperation model from Chapter 2, with its emphasis on

The model is the cooperation model from Chapter 2, with its emphasis on