Berkeley Program in Law and Economics

We advance a theory explaining the use in commercial contracting of specific and vague terms (rules and standards), as well as terms allocating litigation burdens, as key mechanisms for efficient contract design in a world of costly litigation. Economic theories of contracts and contract law postulate that parties will not contract with respect to observable facts that are nonverifiable - that is, where the cost of proving these facts to a court exceeds their benefit in the contract. Scholars apply this postulate to predict that parties will tend not to agree to vague contract terms. In fact, however, vague terms are abundant in commercial contracts and their enforcement need not entail excessively high litigation costs. The conventional nonverifiability concept has distorted contractual analysis because it treats the litigation process as simply the verification of truth to a third party. It thus fails to incorporate the interactive litigation strategies of the parties under the rules governing litigation. In the place of the nonverifiability concern, therefore, we frame the distinction between specific and vague terms - alternatively, rules and standards - as the choice between the parties choosing proxies ex ante and the court doing so ex post. The ex post proxy choice, in turn, is determined to a significant degree by the litigation process, particularly the allocation of procedural burdens and presumptions. There are default burden rules around which commercial parties often contract. Thus, contract terms that combine rules, standards and burdens permit the parties to select useful proxies ex ante, when their interests are aligned, and also ex post when uncertainty is resolved but their interests have diverged. Our analysis thus highlights the more general and valuable lesson of the nonverifiability postulate-- that the anticipated path of litigation is relevant to contract design.