Optimal Contracts With Enforcement Risk

Abstract

I build a model where potentially biased judges verify complex states by interpreting an imperfect signal whose noise captures factual ambiguities. In a sales and a financial transaction I show that judicial biases amplify and distort factual ambiguities, creating enforcement risk. To insure against such risk, parties write simple noncontingent contracts that optimally protect the party that is most vulnerable to judicial error. These results shed light on the empirical association between law and finance and rationalize salient features of real world enforcement regimes.

Enforcement quality and the use of earnouts in M&A transactions: International evidence

“…Our hypotheses are built based on prior theoretical finance work. Gennaioli () shows that, in a judicial state verification model, the mere presence of factual ambiguity about a project's outcome (e.g., uncertainty about the actual performance of the target company in an M&A transaction) does not prevent the parties involved in the transaction (e.g., bidder and target) from writing fully contingent contracts. Such contingent contracts can be optimally chosen when the parties feel protected by a judicial system in which judges are able to obtain information on the project in an unbiased manner which allows them to decide fairly on disputes that could arise between the parties on the actual performance of the project.…”

Securing Property Rights

“…2 Judicial discretion is central to the analysis of legal rules (Frank 1932;Posner 2005). Courts' ability both to bias their interpretation of the law and to distort their findings of fact is a crucial factor driving the evolution of tort law and liability (Gennaioli andShleifer 2007, 2008;Ponzetto and Fernandez 2008;Fernandez and Ponzetto 2012), as well as the development of contract law and the evolving structure of privately optimal contracts (Gennaioli 2013;Gennaioli and Ponzetto 2017). 3 Our distinction between disputable and indisputable facts is different from that between verifiable and nonverifiable facts used as a foundation of incomplete contracts (Hart and Moore 1988).…”

Property Rights, Transaction Costs, and the Limits of the Market.

“…When the input is an idea or know-how for instance, v might be seen as the expenses supported by the downstream firm to let the upstream firm understand how to incorporate his input in the old production process, c is the cost of providing the input, and γ can be interpreted as the probability that, in a lawsuit for breach of contract launched by the downstream firm, a court allows the upstream firm to charge for the input provision (1 − δ) λ instead of 0. This setup squares with the idea that courts display personal biases and arbitrarily evaluate the evidence when certain states are hard to verify and so subject to interpretation (Gennaioli, 2013). Then, the parameter γ can also be seen as the share of pro-upstream firm courts.…”

“…This assumption squares with the idea that courts exploit unverifiable information to favor the party they prefer regardless of the contract terms (Gennaioli, 2013). When the protection of property is strong, the risk of being held-up discourages the downstream firms from innovating.…”