Contract Interpretation Redux

Contract interpretation remains the largest single source of contract litigation between business firms. In part this is because contract interpretation issues are difficult, but it also reflects a deep divide between textualist and contextualist theories of interpretation. While a strong majority of U.S. courts continue to follow the traditional, "formalist" approach to contract interpretation, some courts and most commentators prefer the "contextualist" interpretive principles as exemplified by the Uniform Commercial Code and the Second Restatement. In 2003, we published an article that set out a theory of contract interpretation to govern agreements between business firms. In that article, we support a formalist theory of contract interpretation. Our article has prompted a number of anti-formalist responses. In our article we argued that, although accurate judicial interpretations are desirable, accurate interpretations are costly for parties and courts to obtain. Thus, any socially desirable interpretive rule would trade accuracy off against contract writing and adjudication cost. This trade-off implies that risk neutral business parties will commonly prefer judicial interpretations to be made on a limited evidentiary base the most important element of which is the contract itself. But importantly, we also argued that commercial parties’ preferences along this dimension will be heterogeneous. Thus, any interpretation rules the state adopts should be defaults and the state should defer to the expressed preferences of particular parties regarding interpretation. This Review Essay clarifies and extends these arguments. We briefly summarize empirical data that support our theory, and respond to our critics. Although much academic commentary suggests otherwise, both the available evidence and prevailing judicial practice support the claim that sophisticated parties prefer textualist interpretation. Sophisticated commercial parties incur costs to cast obligations expressly in written and unconditional forms to permit a party to stand on its rights under the written contract, to improve party incentives to invest in the deal, and to reduce litigation costs. Contextualist courts and commentators prefer to withdraw from parties the ability to use these instruments for contract design. The contextualists, however, cannot justify rules that so significantly restrict contractual freedom in the name of contractual freedom.