A friend of mine (and incidentally a co-author of mine) Didier Joos de ter Beerst has drawn my attention to a paper by Tufts University Karen Eggleston, University of Chicago Law School Eric A. Posner and Harvard University Richard Zeckhauser entitled "Simplicity and Complexity in Contracts". Put simply this paper is a gem and a must read! (DownloadHere)
No equation, no scary symbols, just plain English. The main theme of the paper is the following: Why is that literature in the law and economics of contracts advocate "highly complex and fine-tuned contracts" while in practice many contracts are simple? What are the advantages and disadvantages of complexity over simplicity?
This paper is a genuine "tour de force". If you were not yet convinced that simplicity is what comes after you have gone through the ins and outs of complexity, what follows should convert you. Great lesson too for academic researchers who more often than not tend to propose "mechanistic" views of the world.
A few definitions are in order.
Complexity: Most people these days think that all contracts
are complex. As a matter of fact, they are less complex than theory
suggests they should be and that's why a proper definition of
complexity is in order. According to the authors, “complexity refers
to three dimensions of the contract: (1) the expected number of
payoff-relevant contingencies specified in the contract; (2) the
variance in the magnitude of the payoffs contracted to flow between the
parties; and (3) the cognitive load required to understand the
contract. Each component of complexity is measured along a continuum:
contracts are more or less complex."
In other words, lengthy boilerplate provisions do not necessarily imply a complex contract. However seemingly "simple" contracts may be complex because they specify sophisticated contingent payment schedules between the parties while being short (a good example is the term sheet of a structured derivatives trade).
Completeness: Related to complexity is the concept of completeness. A contract is complete if all relevant future states of the world can be identified and verified by a third party upon their occurrence. Obligations are then allocated for every state of the world. A complete contract may not always be complex. For instance, its terms need not vary substantially across relevant states of nature. A complex contract does not imply completeness. Indeed, a complex contract may fail to identify all relevant states of the world.
In the real world contracts are incomplete (even though lawyers strive to make them more complete) but not as complex as theory would predict. The authors quote the example of architects who are paid either flat or per hour. You don't find hybrid contracts that would imply a minimun flat fee + a variable fee. Lawyers are either by the meter or success fee. Meter is potentially bad because lawyers have a clear incentive to spend too many hours (remember lawyer jokes?). Success fee is bad too because lawyers may take too risky positions to their clients's taste (after they are long a call!).
A priori, contracts should be complex because 1/ the environment is uncertain, so to capture its many facets requires a complex contract, 2/there are information asymmetries and monitoring difficulties (think of Enron's shareholders and employees for instance), so the contract should cope with them, 3/the government edicts rules (think of usury laws), so parties enter convoluted contracts to circumvent them.
So far so good. These are good and intuitive reasons why contracts
should be complex. Well, real world, they are not as complex as one
According to the authors, here are the main reasons why:
- Environmental complexity is not enough to warrant contract complexity. This is precisely the point the authors make. You need more than this.
- If negociations costs (agree on terms for contingent allocation of obligations) are high relative to the value of the transaction, simplicity may prevail whatsoever (sorry for lawyers!).
- Asymmetric information: Even though a party has information that may make its position better, it may decide not to reveal it because it may change the behavior of the other party (by telling the other party how much it cares for this or this). Again simplicity may prevail.
- Monitoring dynamics: Think of having your car
to be repaired. you need it back fast. So you could draft a contract
where the repairman is compensated as a function of the speed of
repair. Great but what a sloppy job you end up with. Might have been
better off with a simple fixed fee contract. Again, simplicity might be
the best bet.
- Fairness convention: Despite the many good reasons for having a complex contract, parties may decide that they are better off sharing a larger pie than having to fight over a larger share of a smaller pie. So, 50/50 of any profit or loss may for instance be a better deal than trying to predict each single profit or loss state of the world and arguing on how to split the payoffs in each of them. Commercial life is replete of such conventions. Again, simplicity wins.
- Trust and reputation: Having been an investment banker myself, this one rings the bell. Indeed, as a derivatives banker you may have produced your best term sheet ever (bells and whistles if Euro does this, if Libor does that, if Greenspan does not do this and so on and so forth). End result, client shys away because he or she thinks that he or she may miss some loopholes that you gonna take advantage of. Worse, it may suggest to him or her that your only thought was not his or her well-being but yours (especially knowing that you live on bonuses!). So, again simplicity may be the only way to print the ticket.
- Judicial enforcement costs: Never forget that provisions may have some day to be enforceable by a court. If they cannot be, what the heck? If judicial enforcement is expensive or unreliable, your better anticipate this and shoot for a simpler version.
To summarize in the authors' own words:
"One normative implication of our analysis is directed to lawyers, and this is simply that more detail is not always good. Lawyers tend to make contracts as detailed as possible because they want to resolve every possible future contingency in advance. But detail makes for complexity, and complexity can sow distrust, overwhelm the cognitive capacities of the parties, absorb resources, and have many other negative consequences. Complex contracts may be unnecessary when courts are sophisticated and futile when they are dull."