Anderson and Nyarko's Cool New Papers on Contract Evolution

Two of the contracts papers I’ve been most looking forward to this fall have just been posted on ssrn. They are are Rob Anderson’s “An Evolutionary Perspective on Contracting: Evidence From Poison Pills” (here) and Julian Nyarko’s “Stickiness and Incomplete Contracts” (here).

Both papers aim at deepening our understanding of how contracts evolve and, in particular, why they evolve in ways so very different from the standard model used in law schools where parties are assumed to negotiate for an optimal set of terms for their relationships.

One would predict a very different set of contract terms for parties if one takes the contract production process seriously and thinks of contract provisions as products (ala Barak Richman, here) or product attributes (ala Doug Baird, here).  Specifically, Rob and Julian both use models of contract production where new contracts are constructed by building on pre-existing templates.

In this world, one should expect a high degree of path dependence in the data.  And that is precisely what Rob and Julian demonstrate, looking at two very different areas of commercial contracting – poison pill and choice-of-forum provisions. The implications of their papers, both of which are studying the most sophisticated and well-heeled of all contracting parties, for the one of the core exercises in contract law – how should judges interpret contracts – are considerable.  That said – and this is not meant to take away from the two papers at all -- these papers are more about empirically documenting and understanding the phenomena than normative questions of what judges should be doing.

There is an enormous amount of new material in both papers and I will not do more than scratch the surface in terms of their respective contributions.  Here, however, are a couple of things about each of the papers that stood out to me.

Rob’s paper builds on his excellent prior work on merger contracts with Jeff Manns (e.g., “The Merger Agreement Myth”, here).  In this paper, he starts out from first principles by asking why, in a world of inevitably incomplete contracts, using templates as opposed to drafting from scratch, is the optimal contract design strategy.  This is so because it is impossible to anticipate all of the future contingencies that might occur and one way to utilize the learning of the past by prior lawyers is to use their contract template. The downside though is that one is using a template that one necessarily does not fully understand (indeed, that’s why one is using it – because one’s predecessors figured out stuff that one is trying to take advantage of, without fully knowing what it is that they figured out).  I was sold on the paper on the basis of this incomplete contracts insight alone.

But it gets much better. In a cool move, Rob next uses models from biology (where, of course, thinking about evolution is all over the place and highly sophisticated) to construct a model of contract evolution.  The data that he uses on poison pills is well suited to his inquiry, in part because this is a provision whose origin is relatively recent and well known. The graphics that document how contracts evolve, even though they are well beyond my capacity to produce, are impressive and interesting. As a general matter, I greatly appreciate that Rob writes about both the use of machine learning and biological models in an understandable fashion (although I suspect that I understand a lot less than I think I do).  Bottom line: Path dependence plays an enormous role in contract evolution and, given that, we need to take steps to better understand how path dependence plays out under different sets of conditions.

Julian’s paper also demonstrates the importance of path dependence in determining the shape of contracts by providing one the most impressive demonstrations of the existence of contract stickiness I’ve seen in the literature. Using a powerful set of data mining tools, he looks at choice-of-forum clauses in over half a million contracts scraped from SEC filings. These are among the most important and basic provisions in a contract – ones one might think would always be the product of careful tailoring by the lawyers – and yet what Julian finds (stunningly, I think) is that one of the best predictors of whether a new contract includes a choice-of-forum clause is whether the template being used to supply the first draft of the contract contains such a clause. Aiyiyiyi!

It is one thing to find blind mindless copy-paste behavior with some obscure latin clause that get repeated by rote in contract after contract because no one remembers why it is there and, therefore, is too scared to delete it (yes, this is what I spend my time studying – here). But the choice-of-forum clauses?  I guess I should not be surprised, given that I only recently was reading John Coyle’s work on bizarre evolutionary pattern of the equally, if not more, important choice-of-law clauses (here).  But I’m still surprised at the degree of stickiness Julian finds. 

One question that I’m curious about, that I hope that Rob, John and Julian will expand upon in future work, is whether the degree of stickiness or type of path dependence varies as a function of the type of industry. The reason I ask is that on the few occasions when Bob Scott, Steve Choi and I got to present our work on stickiness in sovereign bond pari passu clauses in front of audiences with a smattering of transactional lawyers, the M&A and private equity lawyers in the audience would sometimes (ok, always) assert that contracting practices in their worlds did not suffer from these issues because they were just so much better at contract drafting than the hapless sovereign bond lawyers we were studying. Having been a hapless sovereign bond lawyer myself, I always felt a pinprick at this. I’ve also heard assertions that the copy and paste routines used by the law firms in different countries (e.g., UK, Germany, US) may differ.  If so, perhaps the pattern of path dependence will differ.  Years ago, when working on some sovereign debt project (yes, low status compared to fancy private equity), I vaguely remember thinking that the patterns of governing-law clause evolution were different in German, Japanese and US contracts.  But I was studying something else at the time and that observation quickly disappeared to the back of my mind until reading the aforementioned papers.

Rob and Julian, bravo!

Comments

[Joey Sommer]

I don't understand Mitu's rationale for blindly using templates. I've done a fair amount of high-resolution drafting in my time. I always thought that one should start with a blank sheet of paper, do a preliminary draft, and *then* look at the wisdom of the past. It's a lot more work, but a lot less mindless. On the other hand, no junior lawyer with any respect for their career would proceed that way.

I usually blame market irrationality on agency costs, anyway. It's better to harm your principal than discomfit your boss.