Monday, March 30, 2009

My Iconoclastic Approach to Contract Theory (or Its Ultimate Failure) - The Financial Crisis Edition

Posted by Jeff Lipshaw

I was reading Bill Saporito's article in the March 19 Time on how AIG got "too big to fail," and one comment jumped out at this contract theorist, particularly after having just recently looked at another take on the relationship between contract and promise.  Last year, Seana Shiffrin (UCLA) published an article in the Harvard Law Review called The Divergence of Contract and Promise, and its thrust was that, to the extent contract law let promise-makers off the hook as, for example, by the doctrine of efficient breach, it was inconsistent with the flourishing of moral agency.  I responded to that piece with my own essay in the Canadian Journal of Law & Jurisprudence. 

No, thank God, there was nothing on contract theory as such in Time.  It's difficult, however, to avoid the subject of contracts (or their limits) when the issue is financial systemic risk.  One way of looking at financial systemic risk is the limit of contract.  What AIG provided was an insurance contract against default on a security known as a collateralized debt obligation (CDO).  "Credit default swap" or CDS is a fancy name for the insurance contract.  The security issuer paid a premium to AIG (which AIG got to book as revenue), and AIG promised to pay the value of the security if there was an underlying default.  Of course, the trick in insurance is setting reserves for potential claims, and as long as the risk is diversified it usually works (assuming you reserve enough, which is a good question here).  Any middling competent deal lawyer knows that you can have the fanciest indemnification provisions in the world but they are worth diddly-squat if there's no (or not enough) money backing them up.  And that's the problem here.  The whole system (game?) of contract law breaks down, or becomes irrelevant when this extra-systemic aspect comes into play.  Oops, counterparties aren't supposed to go broke.

The article does a pretty good job of spelling this out.  What really got my attention, however, was a comment from Maurice Greenberg, the exiled former CEO of AIG, reported thusly:

In a rare interview, former CEO Greenberg, who is suing AIG and being sued by the company over financial-management issues, tells TIME that once the company lost its top credit rating, AIG FP should have stopped writing swaps and hedged, or reinsured, its existing ones. But Cassano's unit doubled down after the spring of 2005, writing more and more subprime-linked swaps as the ratings plunged, which made the possible need for collateral enormous in the event its debt was downgraded. The downgrades occurred in 2008. "Of course they were going to run out of money," says Greenberg. He adds that as the liquidity crunch hit in 2008, AIG FP should have renegotiated terms with the banks to ease their demands on collateral. "You can renegotiate almost anything, anytime." (Emphasis added.)

Wait a minute! For classical contract formalists, what about the "sanctity of contract"? For Professor Shiffrin, what about the morality of promise-keeping? For my friend Rob Kar, late of Loyola-LA and soon of Illinois, what about second-person morality? And for all the economists out there, what about opportunism?

A blog post is no place to do anything other than suggest a direction, and so that's all I will do.  My suggestion is that the "theory of everything" explanation of contract law is futile because of the paradox of the search for foundational principles.  The morality theory founders because it doesn't take us long to dispose of the idea that promise-keeping (as the moral basis of contract) isn't as foundational as it's cracked to be.  The economic theory founders because if the contract obligor is relieved from his opportunistic impulse by the fact the contract obligee gets more utils out of the new deal, then the utilitarian justification for contract law either explains everything or nothing, but is wholly unpredictive.

For more on this, see Freedom, Compulsion, Compliance, and Mystery:  Reflections on the Duty Not to Enforce a Contract, 3 Law, Culture, and the Humanities 82 (2007), whose opening hypothetical might well describe the moral-legal dilemma of an AIG employee who had a right to a bonus, but for some reason other than "law" decided to give it up.  Also see some of Jody Kraus's later work on this.  In the meantime, ponder whether Greenberg's comment is pragmatic or unprincipled, moral or immoral, legal or illegal, reconcilable with law or not?

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You read Time? Boy, that's old school, Jeff. I would never have found this without you.

Anyway, Andrew Gold has a new article called "A Property Theory of Contract" that may help people who are thinking about this, too.


Posted by: Gordon Smith | Mar 30, 2009 10:58:43 AM

Nice post! A quick point though: it is really about the failure of trying to theorize about contract law in either promise-based or consequentialist terms. On the contractualist account I've been developing, one can take full account of the economic facts under discussion, along with the distinctive role that law plays in helping to support modern market economies, when determining what rules would best meet the relevant contractualist standard. (You just allow knowledge of these facts behind the veil of ignorance--or at least that is one way of articulating things.). My own view is that this would not only allow for the renegotiation of contracts like these, but also more substantive regulation of some market activity, along with certain (albeit typically exceptional) protections to guarantee fairness within each bargain. I have written about this in Contractualism about Contract Law, and, for these reasons, I am still hopeful that theory (at least of the right kind) may prove illuminating-- even on issues like these.

For what it is worth, I am also inclined to think that Seana has identified a problem that is very real in principle but that could be significantly mitigated if we could justify some of these divergences between contract and promise not on consequentialist but rather on contractualist grounds. These grounds should be more acceptable to the ordinary moral agent. But we would also need to stop thinking of contracts as promises and get a clearer sense (including among the public) of the very different roles these moral and legal rules play in our social lives. The second-person standpoint arises in each, in my view, but the contractualist standard that we are committed to should recommend systems of rules with different contents in morality and law.

There's nothing truly good about this financial meltdown; but I'm happy its getting us to think more deeply about contract law. And sorry for the brevity: I'm writing from my blackberry, and my fingers hurt!

Posted by: | Mar 30, 2009 12:33:26 PM

Oops--I just realized that my last comment didn't include who it was from. Damn blackberry!

Posted by: Rob Kar | Mar 30, 2009 12:36:08 PM

I might be missing your point, but I'm not sure why renegotiation is a problem for the sanctity-of-contracts or the morality-of-promise folks. So long as you stand ready to perform as agreed, I don't see any problem with seeking renegotiation. Keeping in mind the relational nature of contracts, voluntarily changing the deal to accommodate a counterparty can be in the best interest of both. And if we assume (as in AIG) that the party simply CAN'T perform as promised, then obviously the party has broken its promise. Offering to renegotiate in those circumstances doesn't seem much different than telling the other party to sue.

Posted by: Frank Snyder | Mar 30, 2009 3:33:01 PM

Rob, I think your contractarian approach has promise - if I understand it correctly, it's an understanding that contract law is a social contract, which simply removes it from the "morality" sphere. I'm not well read enough on social contract to know how much of that is a fiction, but the idea that contract law is a social structure resonates with me.

Frank, it's the "stand ready to perform" that I wonder about. Sure, you stand ready to perform, assuming there's something to perform with. But I'm thinking there's something that's not relational contract but is still an acknowledgment that the contract is simply a thing - a reality - not infused with moral content, and can be renegotiated without implication of morality.

Posted by: Jeff Lipshaw | Mar 30, 2009 3:58:28 PM

It would not even give Law Dog paws, to break such a contract. And he has gone at Harvard Law School.

Posted by: Alan Childress | Mar 31, 2009 6:34:35 AM

Jeff, I see you point but I don't know that it necessarily follows. The fact of renegotiation is consistent with either view (moral or amoral). So is the fact of breach. That I don't keep a promise does not show that I do not acknowledge a moral obligation to keep the promise. It just shows that some things (like self-interest) sometimes trump morality.

Suppose, for example, I promise to take my boys to Chuck E. Cheese because of something great they've done. That's not a contract but it is a promise, which (to me) implies a moral commitment. Then suppose I decide I'd rather not go there, so I ask them if they'd rather skip Chuck E. Cheese and go instead to see Monsters v. Aliens. Assuming I'm still willing to go to Chuck E. Cheese if they really want to, how does the fact that we decide to do something else affect the moral situation? And if I just decide not to take them because I'd rather stay home and watch a football game, my breach doesn't show that there was no moral commitment. It just shows that I'm selfish.

I agree that no theory can give a complete description of contract law. But that's true of every of law, because every body of law is an accretion of bits added over the years for a variety of reasons. But that doesn't (to me) suggest that a normative theory is impossible. Law is like a Gothic catherdal, not a Bauhaus box. Bits get added over the years around a central idea, rather than having the whole structure laid out cleanly. And just as there's a central idea behind the design of the cathedral, no matter how many odd incrustations are added, it's possible there's a central theory of contract law.

And no, I don't know what it is . . . .



Posted by: Frank Snyder | Mar 31, 2009 8:43:42 AM

Frank, as to the first point, we completely agree. I think there's an overlap between the legality of contract and the morality of promise, but a lot of the confusion is in overstating the morality of contract and the legality of promise. (I tried to articulate that in Duty and Consequence: A Non-Conflating Theory of Promise and Contract, in the Cumberland Law Review.)

What I tried to explore (moderately incoherently) in the LCH essay was how we should deal with the promisee's moral obligation, if any, not to accept the fruits of a contract to which there is indisputable legal entitlement, but an equally indisputable lack of moral entitlement.

My point in each instance is that the law created by the contract necessarily reifies the relationship of promisor and promisee as of the moment of the contract, but that morality (whether consequentialist or deontological) moves on (the moving finger having writ...), and in the next moment, or the next week, or the next year, what both promisor and promisee ought to do is a new moral question, of which keeping a promise, or holding another to a promise, is but one factor to consider.

Posted by: Jeff Lipshaw | Mar 31, 2009 1:12:59 PM

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