Contract law has a production problem. Commercial parties require a contract law that is both efficient when it is created and also adapts efficiently when commercial circumstances change. But currently no legal institution exists that can satisfy both of these criteria. Three legal institutions produce commercial contract law today: courts, statutes that regulate discrete areas, and private lawmaking bodies that create general contract law rules.
As we will show, each has limitations. Common law courts develop default rules that are efficient when they are created and are updated as economic conditions change. But lawmaking through the judicial process only produces a restricted set of general contract law rules, and updating is slow: These constraints reflect the limited capacity of courts to address more particular commercial practices adequately.
In response, both public and private lawmaking institutions have created specialized statutes that specify rules for discrete legal areas such as secured debt, commercial paper, financial transactions, and bankruptcy.
These specialized statutes are useful complements to the general law of contracts. Yet, the rules were enacted at the instance of cohesive interest groups: The public interest was poorly represented in the enactment process.
The felt need for more and better rules governing the general law of contracts led the private lawmaking groups to produce the law of sales in Article 2 of the Uniform Commercial Code (UCC) and the two Restatements of Contracts. These private lawmaking efforts developed new default rules that covered a wider range of contract law issues than the common law, but history has shown that the rules do not adapt to changing circumstances.
The source of the difficulties that plague the commercial law production process is the singular fact of obsolescence.
A commercial law rule, whether a default rule or a mandatory rule, is obsolete when it is no longer “apt.” An apt rule efficiently solves a “contracting problem” in the current state of the world and also solves the problem in future states of the world that are “relevantly similar” to the current state.
But if in a future state the contracting problem takes a different form, the apt solution to the problem can change as well. An obsolescence concern exists, therefore, when a legal rule becomes inapt: That is, the rule does not solve the contracting problem in its current form.
Obsolescence is a significant concern because the commercial world of today is dissimilar in significant ways from the world that existed when our leading commercial laws were created.
UCC Article 2 took its current form by 1952, and the Restatement (Second) of Contracts was completed by 1979.
Neither body of law has been materially amended since then.
The obsolescence concern is also present in discrete legal areas like bankruptcy that enact specific statutory solutions. The reorganization chapters of the Bankruptcy Code were last comprehensively redone in 1978.
But today many insolvent firms are directly sold to the market through an ill-defined process rather than reorganized under the Code’s elaborate rules.
An obsolete term in a restatement, statute, or even a private contract is not innocuous.
There are two concerns. First, suppose that a UCC sales law default rule efficiently solved a contracting problem when enacted, but the world has evolved to a different state in which the problem takes a different form. The private lawmaking groups created the UCC default rule because it was too costly for contracting parties to solve the problem themselves.
If it remains too costly for private agents to solve the problem efficiently in its current form, obsolescence causes parties to treat the problem with second-best solutions.
The second concern with obsolescence is that a vestigial default could transition from being harmless but unhelpful to being dangerous. Such transitions can occur when a default applies linguistically, but not substantively, to the current version of the parties’ contracting problem. A party behaving strategically may then attempt to exploit the linguistic fit to generate an unfair or inefficient judicial interpretation in its favor.
The persistence and significant costs of obsolescence demand a critical reexamination of the institutional features of the commercial law production process. This Article focuses specifically on the comparative institutional question: How have private markets and the three legal institutions governing commercial contract law—courts, public and private rules for managing specialized areas, and general contract law codifications—fared in their responses to the obsolescence concern?
We begin that inquiry by briefly reviewing how the developments over the past one hundred years have produced our modern commercial law. For around 700 years, from 1200 to 1900, only one institution—common law courts—functioned in England and America to produce commercial law.
Courts could function unaided for so many years because intrinsic to common law adjudication is a mechanism for generating a particular subset of efficient contract law rules. Consider, for example, a case of first impression in which the parties’ contract lacks a term to resolve their dispute, so the court has to fill the gap.
The court’s decision may become a rule when future parties recognize that the initial court’s resolution of the case faces them with a choice: to respond to the first case with an express term that regulates the same dispute or to leave a gap in the contract. If a subsequent contracting dyad leaves a gap, the first case becomes a precedent in the sense that the court will resolve the later dyad’s dispute with the rule that it used to resolve the initial dispute. Rules in cases thus become default terms in contracts that are written later unless parties contract out.
A court’s decision can function as an efficient precedent, however, only if four conditions are satisfied: (1) Parties in other commercial contexts face the same contracting problem as the parties in the first case; (2) The solution to the problem conditions on verifiable information;
(3) The later parties left a contract gap: Their agreements did not otherwise regulate the problem, thereby creating the opportunity for later courts to rule on the issue; and (4) The initial court’s ruling solved the problem as the parties would have solved it had they contracted over it. But condition (4) implies condition (3): The future parties will have left a contract gap only because the rule in the first case efficiently solved their problem.
This sketch of the common law adjudication mechanism shows that a common law contract rule has two key properties. First, the rule is “transcontextual”: The rule efficiently solves a contracting problem for parties functioning in diverse contexts.
If the rule in the first case lacked this property, the rule would be a historical curiosity only. Future parties in other areas would not have left a contract gap, but rather would have contracted about the problem for themselves.
The second property is that the rule roughly tracks changing commercial patterns. When commerce materially changes, parties do different deals under new contracts. If the future parties’ contracts nevertheless also leave a gap where a solution to the problem could be found, the rule in the first case continues to function as a precedent: The rule has been “updated.” But if parties functioning in new commercial situations create contracts that expressly govern the issue, the rule in the first case becomes vestigial: It has no current function. However, the common law mechanism, triggered by current disputes, will then create new rules when the four conditions specified above are satisfied.
The updating feature of the common law mechanism has an inherent limitation, however. Parties in different commercial contexts often require solutions that are specific to their circumstances. But generalist courts are ill-equipped to supply specific solutions to particular industries. The solution they suggest for a specific problem will likely not be the outcome that the parties would have specified had they contracted over the issue. That failure, in turn, implies that future parties in the industry would not leave a gap in their contract, and no default rule would be formed. Private lawmakers responded to this regulatory gap by creating discrete bodies of commercial law, including secured credit to regulate transactions between creditors and their debtors, and commercial paper and bank deposits to regulate short-term financing transactions.
Many of these discrete lawmaking efforts have been regularly updated as focused interest group pressures stimulate reform proposals.
Yet, this focused response to the risk of obsolescence raises a further concern: Interest group pressure produces specialized commercial rules that are privately efficient but not necessarily socially efficient.
This disregard for the public interest justifies a continuing role for general contract law rules that take broader social interests into account.
The American legal establishment long recognized, therefore, that a modern economy benefits from a law that applies to contracts generally, but for several reasons, American lawyers were unsatisfied with the common law mechanism. The first reason follows from our earlier analysis: Default rules are slow to form.
Litigation must proceed over time in different contexts before a default rule is fully formed. Consequently, most of the common law default rules were developed in the nineteenth century following the Industrial Revolution, and the process of rule development slowed considerably thereafter.
Because the process of developing default rules had slowed, courts had relatively few general rules with which to fill gaps in incomplete contracts.
This stasis in common law rule development followed from the second reason: Courts are poor regulators of a modern economy. Courts cannot find facts, apart from case records, and so they cannot hold accurate views of the context in which a possible rule will function and the effects of current rules. In addition, judges are generalist lawyers. The typical judge has little commercial expertise and cannot effectively resolve the economic issues that a possible rule may pose. Another rule-generating mechanism was required.
Widespread dissatisfaction with the common law process produced the two major interventions that sought to change contract law itself. The first effort at a codification of contract law occurred at the turn of the twentieth century when the Uniform Law Commission (ULC) produced the Uniform Sales Act.
That effort soon proved obsolete, however, and throughout the interwar period only the courts were able to keep sales law current with changing commercial practice.
This led to the second effort by the American Law Institute (ALI) and the ULC in the mid-twentieth century to codify the general law of contracts.
Article 2 of the UCC governing sales transactions has since been enacted in every state (except Louisiana), and it was followed by the Restatement (Second) of Contracts, which usefully summarized important contract doctrines for common law courts.
The Restatement also had a distinct policy focus, identifying some contract rules as better solutions to a given contracting problem than others.
The justification for the codification of general contract law rules follows from the dissatisfaction with the common law process. UCC drafters and the ALI members responsible for particular restatements are thought to be more expert and to have more real-world knowledge than the typical common law judge.
Moreover, the felt need for more default rules is genuine: Private parties will not solve every contracting problem that they face.
Contracting parties seldom can internalize the full gain from creating a useful solution to a common contracting problem—others can copy their innovation—but nonetheless they bear the full cost.
When the cost exceeds a contracting dyad’s share of the gain, the problem will not be solved efficiently without outside help. Private lawmakers can use their expertise and knowledge to solve these common problems and supply contracting parties with the solutions in the form of UCC or Restatement sections. In prior work we have criticized the rationale for this method of supplying contract terms on the ground that the ALI and ULC are also institutionally limited.
The focus here, however, is on the deeper institutional problem. As discussed above, a public program of supplying contract law rules must satisfy two conditions: The rules must first solve contracting problems as the parties would have solved them; and second, the rules must update promptly as economic conditions change. In this Article, we show that even if the ALI and ULC once supplied rules that parties themselves would have chosen, these private groups no longer do so: Their rules remain but the problems have changed.
This Article proceeds as follows. Part I describes the dramatic changes in contemporary contracting practices that have rendered state-supplied default rules, as well as those we designate as “quasi-mandatory” rules, obsolete.
We develop an economic theory that shows parties will reject an obsolete state-supplied default because the term cannot solve the current version of their contracting problem and bad faith parties could exploit the term strategically.
But parties are unlikely to create a new term equivalent to an apt state-supplied default because of its excessive cost.
The theory predicts that parties instead will replace the obsolete default term with second-best solutions.
Yet, the obsolete default lives on. Similarly, parties can only escape the constraints imposed by an obsolete quasi-mandatory rule by costly contracting around the rule. Finally, Part I analyzes the coordination problems that may prevent private parties from revising obsolete terms in standardized interdependent contracts.
Part II provides evidence of the persistence and costs of obsolete terms.
Here we show how the theory developed in Part I explains many of the contracting patterns we observe as parties attempt to adjust to the constraints imposed by obsolete default and quasi-mandatory rules.
Consistent with the theory, parties avoid obsolete terms by settling on less efficient alternatives.
This Part also presents evidence that parties in large, multilateral markets often fail to revise standardized obsolete terms notwithstanding the heightened level of litigation risk that they face as a result.
Part III considers the several systemic reasons that explain why UCC Article 2, the Restatement, and the Bankruptcy Code remain rocks in the river of changing commercial practice.
Obsolescence persists when coordination on an efficient replacement fails because individual parties would bear too much of the cost and internalize too few of the gains to reward efforts to initiate legal change.
The private lawmaking bodies that created today’s obsolete contract law rules also are poorly equipped institutionally to create current ones.
These institutions meet episodically: They have little incentive to update the rules by adopting controversial reforms, and interest group competition can instantiate a status quo bias.
And when the rulemaking process is captured by insiders, as in the case of bankruptcy, specialized rules also can become “sticky.”
Part IV revisits commercial law’s production problem by asking how other institutions that supply commercial law rules have responded to the obsolescence concern. Some private interests have created specialized contract terms that parties are then invited to adopt in their contracts,
but this solution to updating is still underproduced.
The two public institutions that are largely free from persistent obsolescence are specialized lawmaking bodies and common law courts. Organized interest groups that supply rules for specialized fields can update their rules but at the cost of promoting private interests over the public interest.
What remains are common law courts, the institution with which we began. Courts’ rules are efficient and update over time, but at first blush do not appear to cover much of the ground. We show, however, that once artificial institutional boundaries are set aside, the activity of common law courts is more vibrant than is commonly assumed.
Part V concludes that the splintering of our general contract law into contract laws for specialized fields—such as corporate, bankruptcy, and financial contracting—points to an emerging institutional response to the externalities that the specialized laws create.
We have two closing observations. First, the common view is that general contract law is created by two institutions: common law courts and “private legislatures” such as the ALI and the ULC that produce UCC Article 2 and the Restatements. This view is incorrect because the contract law products of the ALI and the ULC are largely obsolete.
Today, there are courts and episodic, specialized interventions. The question we raise is whether this is the best American law can do.
Second, we note the novelty of our analysis. There are two significant prior contributions. Grant Gilmore observed that early twentieth-century codification efforts became obsolete, but for reasons that differ from ours. According to Gilmore, these uniform law codifications were intended to “embalm the past”—that is, to solve yesterday’s doctrinal problems and enact the solutions into law.
A codification that does this will inevitably become obsolete because the future poses different doctrinal problems.
But the UCC and Restatement were not so much meant to solve old legal problems as to solve, in the form of default and quasi-mandatory rules, current economic problems. In contrast to Gilmore, we show that such laws become obsolete only when the economic problems either disappear or take new forms.
Guido Calabresi wrote an important book about obsolete statutes and judicial responses.
Calabresi’s subject was the statute that had outlived its animating purpose but that continued to affect behavior because it was a statute.
He then asked how courts respond to an obsolete law by analyzing the strengths courts exhibit and the constraints they function under when attempting to make such laws current.
We also observe that obsolescence occurs for statutes that are difficult to update. But, in contrast to Calabresi, we analyze the case of an obsolete commercial law that no longer affects behavior because parties contract out of the law’s terms. As a consequence, our subject concerns how parties respond when a law that was supposed to solve the parties’ contracting problems no longer does so. Thus, the comparative question this Article asks—which legal institution can best create an efficient law to regulate commercial contracting—is entirely novel. Nor has any prior work analyzed contract obsolescence as a discrete problem to ask why and where such obsolescence exists and how it can persist. We recognize, however, that our more important contribution may be to introduce the subject of comparative institutional analysis to private law fields.