Courts of Law and Unforeseen Contingencies

Courts of Law and Unforeseen Contingencies

Journal of Law, Economics, and Organization 2007 23(3):662-684; doi:10.1093/jleo/ewm017

Luca Anderlini
Georgetown University
Leonardo Felli*
London School of Economics
Andrew Postlewaite
University of Pennsylvania
* Department of Economics, London School of Economics, Houghton Street, London WC2A 2AE, United Kingdom. Email: lfelli@econ.lse.ac.uk
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We study a contracting model with unforeseen contingencies in which the court is an active player. Ex ante, the contracting parties cannot include the risky unforeseen contingencies in the contract they draw up. Ex post, the court observes whether an unforeseen contingency occurred and decides whether to void or uphold the contract. If the contract is voided by the court, the parties can renegotiate a new agreement ex post. There are two effects of a court that voids contracts. The parties' incentives to undertake relationship-specific investment are reduced, and the parties enjoy greater insurance against the unforeseen contingencies that the ex ante contract cannot account for. In this context, we fully characterize the optimal decision rule for the court. The behavior of the optimal court is determined by the trade-off between the need for incentives and the gains from insurance that voiding in some circumstances offers to the agents.