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Omer Pelled & Ohad Somech, The Value of Accuracy in Contract Interpretation (Aug. 5, 2021), available at SSRN.

In the past twenty years or so, the new formalism, led mostly by legal economists, has been quite influential in contract theory. Focusing on commercial transactions between sophisticated firms, leading scholars have questioned the courts’ competence to accurately determine the parties’ intentions and called for a textualist approach to contract interpretation (see, e.g., Schwartz & Scott 2000; 2003).

Two common responses to the new formalism are to deny that economic efficiency is the only value underlying contract interpretation, even in commercial contracts, and to shift attention from negotiated, commercial transactions to standard-form and consumer contracts. In The Value of Accuracy in Contract Interpretation, Omer Pelled and Ohad Somech take a different route. They convincingly criticize one of Schwartz & Scott’s key arguments on the latters’ own terms, thereby casting doubt on the accuracy of mainstream economic analysis of contract interpretation even in bespoke commercial transactions between sophisticated parties.

A key insight of Schwartz & Scott’s theory is that contract interpretation need not strive to effectuate the parties’ true intentions. Rather, courts should apply interpretation rules that most contracting parties would have preferred (while allowing those who prefer other rules of interpretation to opt out of the majoritarian default rules). Furthermore, it is assumed that large commercial firms are risk-neutral. Assuming that there is a range of possible interpretations, and that the payoffs for each party are continuous along this range, a “risk-neutral party cares about the mean of the interpretation distribution, but not the variance. This is because the variance term measures risk while risk-neutral parties are indifferent to risk.” (Schwartz & Scott 2003, at 576). It follows that it suffices for a risk-neutral firm that the mean interpretation equals the correct interpretation. This argument, in turn, lends support for textual, rather than contextual interpretation of contracts: even if taking into account extrinsic evidence can enhance the accuracy of interpretation, as long as a literal interpretation is accurate on average, sophisticated, risk-neutral parties would prefer to save on the extra litigation costs involved in the production of such evidence.

Using a series of simple examples, Pelled and Somech demonstrate that this analysis is flawed. In the first part of the article, they show that even if the distribution of a court’s possible textual interpretations is symmetrically distributed around the mean, risk-neutral parties do care about the variance, because typically a more accurate interpretation increases the joint surplus of the contract. Consider the following example: in a contractual dispute, there are three possible interpretations of a given clause, A, B, and C. Under interpretation A, the seller’s cost of performance is 100, the buyer’s benefit from the seller’s performance is 150, and the joint surplus is therefore 50 (150 minus 100). Under interpretation B, the seller’s cost of performance is 150, the benefit from this performance to the buyer is 250, and the joint surplus is therefore 100 (250 minus 150). Under interpretation C, the seller’s cost is 250, the buyer’s benefit is 300, and so the contract surplus is 50 (300 minus 250). Clearly, rational parties must have meant the contract to mean B, as under this interpretation the transaction yields a joint profit of 100, rather than only 50 under each of the other interpretations.

Now, suppose that a textual interpretation of the contract can lead the court to adopt interpretation B with a probability of 0.5, and interpretations A or C with a probability of 0.25 each. In that case, the expected joint surplus of the contract would be 0.5×100 + 0.25×50 + 0.25×50 = 75. In contrast, a contextual interpretation that would accurately adopt interpretation B with certainty would yield a joint profit of 100. It follows that, as long as the added litigation costs of providing external evidence that would enable the court to reach the accurate interpretation is smaller than 25, rational parties would prefer a contextual, rather than textual, interpretation.

Pelled and Somech go on to show that under plausible circumstances, the textualist approach, which is likely to reduce the accuracy of interpretation, may lead rational parties to adopt inefficient clauses in order to reduce the expected costs of inaccurate interpretation, and may even affect the agreed price. The second part of the article then analyzes how accuracy determines the parties’ preferred interpretative approach, taking into account transaction costs, the possibilities of settlement and renegotiation, the contractual environment, and the type of disputed term. Finally, in the third part of the article, Pelled and Somech argue that their modified analysis is actually reflected in legal practice, focusing on the interpretation of force majeure clauses, alternative dispute resolution clauses, and loan agreements. In doing so, they considerably enrich the economic analysis of contract interpretation and bring its conclusions closer to conventional legal thinking.

Both Schwartz & Scott and Pelled & Somech restrict their analysis to negotiated contracts between not-too-small firms, thus excluding most commercial contracts (which are executed through standard forms), private contracts, employment and consumer contracts, and more. They further limit the scope of the analysis by assuming that firms are perfectly rational, do not care about anything but their profits, and are risk-neutral – assumptions that are all contestable. Finally, they posit that the rules of interpretation should reflect a single normative criterion: welfare maximization, thus excluding other values that should arguably inform contract interpretation, such as fairness (see, e.g., Zamir 1997). Adding the fact that sophisticated firms mostly resolve their disagreements outside of the court system, and not necessarily according to the prevailing legal norms, one may wonder how relevant the discussion is for the great majority of contractual disputes.

I believe that, as long as one keeps in mind its premises and limits, the analysis is important and intriguing. Eric Posner (2003) has argued that economic models generate predictions and normative recommendations that are either wrong (because they rest on too many simplifying assumptions) or indeterminate (because the more complex a model is, the more difficult it is to ascertain all the information necessary for its implementation). According to Pelled and Somech, one of the economic rationales for textualism is problematic even under its simplifying assumptions. Nonetheless, like much of economic analysis in general, the present discussion should be praised for challenging accepted truths and provoking new thinking, even if it does not provide simple answers to complex questions.

Pelled and Somech show that economic analysis does not necessarily lend support for formalism and textualism. Indeed, there is no logical connection between individualism, economic efficiency, and formalism. Yet, as Duncan Kennedy (1976) has argued theoretically, individualism and formalism share similar “visions of humanity and society.” And as Ori Katz (2021) has recently demonstrated empirically, individualists actually tend to be more formalists, and vice versa. Possibly, then, the support of many legal economists for formalism is not a product of the normative or methodological commitments of economic analysis, but rather of ideological inclinations.

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Cite as: Eyal Zamir, The Accuracy of Economic Analysis of Contract Interpretation, JOTWELL (November 30, 2021) (reviewing Omer Pelled & Ohad Somech, The Value of Accuracy in Contract Interpretation (Aug. 5, 2021), available at SSRN),