Albert H. Choi

A Critique of the Odious Debt Doctrine

Defenders of the odious debt doctrine, which bars creditors from collecting sovereign debts that financed the personal consumption of former dictators, argue that this rule would benefit populations following dictatorships and discourage would-be dictators from staging coups in the first place. We show that optimism about the doctrine is based on unrealistic assumptions about the motives and practices of dictators. With more realistic assumptions, the odious debt doctrine could be beneficial or harmful, depending on circumstances. Defenders of the doctrine have not made the empirical case that the net benefits would be positive if the doctrine were incorporated into international law, and there is ample reason for skepticism that they would be.

Should Plaintiffs Win What Defendants Lose?: Litigation Stakes, Litigation Effort, and the Benefits of 'Decoupling'

Abstract In a 1991 paper, Polinsky and Che argue that lowering plaintiffs’ recovery and raising defendants’ damages can deliver the same level of deterrence with fewer filed suits. A subsequent paper by Kahan and Tuckman provisionally corroborates Polinsky and Che’s analysis in an extended model that accounts for the effect of litigation states on litigation effort levels. In contrast, we show that when litigation effort is endogenous, Polinsky and Che’s proposal to lower recovery and raise damages may no longer improve social welfare. We then characterize the kinds of suits where it is in fact suboptimal to set recovery below damages. Of significance for the current policy debate, we find that such suits share many of the empirical premises about litigation that ground conventional arguments in favor of making recovery less than damages. Our findings are robust to the possibility of out‐of‐court settlement, plaintiffs’ employment of contingent‐fee lawyers, and alternative fee‐shifting rules.

Completing Contracts in the Shadow of Costly Verification

Abstract Contract theory typically holds that verification costs are obstacles to complete contracting; yet real‐world contracts often contain provisions that seem costly to verify. We show how verification (or litigation) costs operate as a screen on the promisee’s incentive to sue and as an effective sanction against the breaching promisor. As long as the court’s judgment is correlated with the promisor’s behavior, the parties can design a set of prices (including damages) to provide additional incentive to the promisor through an off‐the‐equilibrium, credible litigation threat. We show that the parties may prefer to adopt a costly signal over a costless signal. Rather than focus solely on either the problems of adjudication or those of contracting (without sufficient regard to how the disputes will be resolved in the future), we take a more comprehensive approach by looking at the design of contracts in anticipation of the path of the adjudication process.

A Rent Extraction Theory of Right of First Refusal

When a seller encumbers a property with a right of first refusal, whenever a third party offers to purchase the property, the right-holder can acquire the property by simply matching the third partys offer. I model the right as a modified auction where the right-holder gets to observe the third partys bid before making his own. I show that, compared to the standard auctions, the right increases the joint profit of the seller and the right-holder by reducing the third partys profit. This result is independent of whether the third party is aware of the rights existence and whether the right creates a welfare loss. Copyright 2009 The Authors. Journal compilation 2009 Blackwell Publishing Ltd. and the Editorial Board of The Journal of Industrial Economics.

Should Consumers be Permitted to Waive Products Liability? Product Safety, Private Contracts, and Adverse Selection

A potentially dangerous product is supplied by a competitive market. The likelihood of a product-related accident depends on the unobservable precautions taken by the manufacturer and on the type of the consumer. Contracts include the price to be paid by the consumer ex ante and stipulated damages to be paid by the manufacturer ex post in the event of an accident. Although the stipulated damage payments are a potential solution to the moral hazard problem, firms have a private incentive to reduce the stipulated damages (and simultaneously lower the up front price) in order to attract the safer consumers who are less costly to serve. The competitive equilibrium–if an equilibrium exists at all–features suboptimally low stipulated damages and correspondingly suboptimal levels of product safety. Imposing tort liability on manufacturers for uncovered accident losses–and prohibiting private parties from waiving that liability– can improve social welfare.

The Effect of Bargaining Power on Contract Design

Over the past forty years, an irrelevance proposition has been prevalent in law-and-economics scholarship: bargaining power should affect only price and not nonprice terms of a contract. In contrast, practitioners and commentators in industry regularly invoke bargaining power to explain static and dynamic variance in nonprice contract terms. This Article unpacks and analyzes the assumptions of the strong- and weak-versions of this bargaining power irrelevance proposition to bridge the gap between theory and the real world. In the first half of the Article, we identify and discuss a variety of explanations for the effect of bargaining power on contract design. These include the effects of shifts in market supply and demand and the effect of negotiating price first and nonprice terms later. In the second half of the Article, we present an in-depth examination of one set of explanations, concerning the impact of bargianing power and information asymmetry on nonprice terms, when the value and cost of nonprice terms vary across contracting parties. In the extreme cases in which one or the other party enjoys overwhelming bargaining power, the efforts of that party to capture a larger share of the surplus by screening or signaling may compromise the efficiency of the nonprice terms. We show that this incentive disappears or is mitigated when bargaining power is more evenly shared between the parties: for example, when a monopolist faces the threat of competition, when the parties can renegotiate, or when they engage in bilateral bargaining with more even bargaining power. As a whole, the Article provides a theoretical basis for interpreting the intuition among market participants that the impact of bargaining power extends beyond price terms. Before concluding, we briefly suggest implications for legal policy, particularly the contract law doctrine of unconscionability.

A RENT EXTRACTION THEORY OF RIGHT OF FIRST REFUSAL -super-*

When a seller encumbers a property with a right of first refusal, whenever a third party offers to purchase the property, the right-holder can acquire the property by simply matching the third partys offer. I model the right as a modified auction where the right-holder gets to observe the third partys bid before making his own. I show that, compared to the standard auctions, the right increases the joint profit of the seller and the right-holder by reducing the third partys profit. This result is independent of whether the third party is aware of the rights existence and whether the right creates a welfare loss. Copyright 2009 The Authors. Journal compilation 2009 Blackwell Publishing Ltd. and the Editorial Board of The Journal of Industrial Economics.

Contract's Role in Relational Contract

A long line of legal scholarship has examined how formal or legal sanctions can deter misbehavior or facilitate cooperation. A second strand of legal scholarship asks how informal or reputational sanctions can accomplish these same goals. Insufficient attention has been paid to why, in reality, these two kinds of sanctions often co-exist and how they interact with each other. This paper attempts to fill this gap by analyzing how the two types of sanctions can be jointly deployed in a long-term, relational contract setting. The paper advances four claims. First, both legal and reputational sanctions are costly: legal sanctions require spending resources on litigation while reputational sanctions can lead to inefficient failures to trade. An optimal deterrence regime must, therefore, make a trade-off between these two types of costs. Second, in achieving optimal deterrence, the two sanctions function as both substitutes and complements. As substitutes, relying more on one type of sanction requires less of the other to reach any desired level of deterrence. As complements, formal sanctions—by revealing information about past misconduct—can improve the performance of the informal sanctions. Indeed, a desire to generate information can explain why contracting parties might want legal liability to turn on a fault-based standard (such as “best efforts,” “commercially reasonable efforts,” or “good faith”). Third, the paper argues that the most effective deterrence regime will often combine both types of sanctions. By keeping legal sanctions low, the regime keeps the litigation costs in check while taking advantage of the informational benefits of litigation. Reputational sanctions, then, can make up for any shortfall in deterrence. Finally, the paper shows how various empirical findings are consistent with the theoretical predictions. * Professor of Law, Washington University in St. Louis School of Law, and Albert C. BeVier Research Professor of Law, University of Virginia School of Law, respectively. We are grateful for helpful comments from Robert Ellickson, John Ferejohn, Gillian Hadfield, Lewis Kornhauser, Barak Richman, George Triantis, and Abe Wickelgren, and participants of workshops at New York University Law School, Seoul National University Law School, University of Texas Law School, University of Virginia Law School, and the 2013 American Law and Economics Association Annual Meeting. Comments are welcome to sbaker@wulaw.wustl.edu and albert.choi@virginia.edu. Baker and Choi Formal and Informal Sanctions Version: January 27, 2014What role do contracts play in long-term relationships? Very little, if any, according to the relational contract literature. It is not the contract that induces promise-keeping but the imposition of (or threat of imposing) relational or informal sanctions, such as suspension or termination of trade. Yet, in reality, parties in long-term relationships write elaborate contracts enforceable through litigation (often with vague, open-ended clauses such as “best efforts”) or set up dispute resolution mechanisms that mimic formal adjudication process. Why go through all that trouble if formal mechanisms are to be used rarely? This paper attempts to answer these questions. The paper argues that formal sanctions have two important advantages that informal sanctions often lack. First, with formal sanctions, parties can design the remedy (e.g., liquidated damages) and even the adjudication process (e.g., arbitration), and such flexibility allows them to decouple the deterrence benefit of the sanction from the cost of its imposition in achieving a better deterrence cost-benefit ratio. With relational sanctions, by contrast, both the deterrence benefit and the imposition cost are largely dictated by the value of future relationship: the more valuable the future relationship, the larger the deterrence benefit from threatening to terminate it, but also the larger the cost of carrying out that threat. Second, the formal adjudication process often uncovers evidence that parties and other market actors can use to better tailor relational sanctions. In fact, the desire to generate more accurate information can explain why contracting parties use vague, open-ended standards, such as “best efforts.” Recognizing these benefits but wary of inducing too much litigation, the most effective means for deterring breach of contract will often combine relational and legal sanctions, an approach commonly observed in the real-world. The paper also shows how various empirical findings are consistent with the theoretical predictions and how the findings can inform courts in interpreting “good faith” obligations.

Optimal agency contracts: The effect of vicarious liability and judicial error

Under the doctrine of vicarious liability, a deep-pocket principal is often held responsible for a third-party harm caused by a judgment-proof agents negligence. We analyze the incentive contract used by the principal to control the agents behavior when a court can make an error in determining the agents negligence. We show that (1) reducing the error of declaring the agent not negligent even when he was (pro-defendant or type II error) is better than reducing the error of declaring the agent negligent even when he was not (pro-plaintiff or type I error) and (2) allowing the principal to penalize the agent even when the court declares the agent not negligent improves welfare. The latter supports the argument that causing an accident (or a reliable allegation of misconduct) should be sufficient to justify a just cause termination of an employee.

Shrink-Wraps: Who Should Bear the Cost of Communicating Mass-Market Contract Terms?

The paper examines the equilibrium quality of mass market contract terms, such as those in end user license agreements, when consumers can read and search for a better set of terms. Firms compete over price and quality of the terms. They can also choose to disclose (speak) the terms to consumers at cost. While all consumers must incur positive search (reading) cost to understand the terms, not everyone cares about the terms equally and they can also buy without reading. The paper examines two legal regimes: one that imposes a duty to read on the consumers and the other that imposes a duty to speak (disclose) on the firms. While neither regime strictly dominates the other in terms of social welfare, the paper shows that (1) as the reading or speaking cost converges to zero, the social welfare continuously converges to the first best; (2) consumers will have different preferences over duty-to-speak and duty-to-read regimes; and (3) the quality of the terms of non-disclosing firms may be higher. The results are consistent with the current chasm among scholars and courts over mandatory disclosure policy and also with the recent empirical findings.