Contracts and Crisis: Nobel Laureate Oliver Hart on Contract Theory and the World of the Pandemic

The coronavirus pandemic has disrupted a large number of ongoing business relationships and generated considerable uncertainty over basic commercial actions. A critical question in this new reality is how parties bound by contracts should proceed in a world that has changed significantly in the space of a few months.

In this Q&A, Professor Oliver Hart, an Analysis Group affiliate, discusses the aspects of his work in contract theory – the study of the optimal design of the contracts that govern economic relationships – that are helpful for resolving the many questions brought about by the pandemic. Professor Hart, the Lewis P. and Linda L. Geyser University Professor at Harvard University, was awarded the Nobel Prize in Economics for his work in contract theory in 2016. He spoke with Analysis Group Managing Principal Chris Borek about incomplete contracts, renegotiation, and how the risk engendered by the pandemic should be allocated.

The coronavirus pandemic has created a public health crisis as well as a great deal of economic uncertainty, which in turn has put pressure on existing economic arrangements. On a general level, how can the study of contracts be helpful in the economic environment triggered by the emergence of the pandemic?

I think many parties are trying to figure out what to do, and specifically are wondering how existing agreements – for example, force majeure clauses that are present in many contracts – will be applied in circumstances that hadn’t really been anticipated. They want to know how to move forward.

What specific ideas from contract theory can be helpful?

With respect to my own research, two important concepts jump out: incomplete contracts and renegotiation.

The concept of contractual incompleteness is familiar to both economists and lawyers. It refers to the idea that it is costly – and in many cases impossible – for a contract to fully account for every eventuality that might arise or govern all the actions to which parties may want to commit. So with respect to the pandemic, parties to many contracts might well be facing an economic environment that was largely, if not completely, unanticipated when they entered into the contract.

What can happen in these situations?

Several outcomes are possible. One of the parties may try to enforce the contract as it stands; if the other party interprets the contract differently or resists, they may end up in litigation. Or the parties may recognize that enforcing the existing contract is inefficient, and that they can achieve a better outcome by renegotiating the contract. Renegotiation can lead to an outcome that is not only more efficient but also more equitable.

Can you give a hypothetical example?

Suppose that I’m a commercial landlord and you rent space from me for your business. We have a contract that calls for you to pay me a certain amount each month. Because of the pandemic, you have no income and can’t afford to pay me. What might happen? I could try to enforce the contract’s terms, though that may not be very fruitful in this instance because it might lead to your eviction.

A second option would be to renegotiate the contract.

Right. We could revise the contract so as to maintain a mutually beneficial relationship in the face of the new circumstances. I might agree to lower your rent for a certain period of time, or defer it until a later date. I could even take some equity in your business so that I see an upside if things improve.

A distinction that’s important here is between short- and long-term relationships. Many contracts involve one-time transactions: The parties agree to the terms of a deal but don’t have an ongoing relationship once it is consummated. But some of the most interesting contracts involve long-term relationships – supply agreements and franchise agreements, for example. These types of contracts often involve relationship-specific investments, which can make it quite costly for either party to swap out business partners.

The nature of long-term contracts often makes renegotiation a more attractive option than enforcing a contract. To return to the example involving the tenant and the landlord: You don’t want to lose the space you rent, and I don’t want to have to search for a new tenant (which involves additional setup costs at the best of times) under materially adverse circumstances. Because neither of us has very good options, the most efficient solution, at least in this case, is for us to stick together and recraft the deal so that it’s reasonable on both sides. If there’s more collective value to us continuing to work together, we should be able to achieve that. Or, to paraphrase Ronald Coase’s famous theorem, rational parties do not leave money on the table.

The allocation of risk is a critical factor in many of the business relationships that have been upset by the pandemic. Can contract theory throw any light on this?

Yes, I think it can. In some situations it seems more efficient for one party to bear the risk than the other party.

To give a simple example: I purchased tickets for three plays, all of which were canceled because the theaters were ordered to close. I don’t think the question of who bears the risk in this situation was spelled out in the terms governing the purchase of those tickets. In effect, it was an incomplete contract.

For most disruptions leading to cancelation, the theater is in a better position to bear the risk because it can buy insurance. In those cases, one would expect, and it would be efficient for, customers to get a full refund. The pandemic is more complicated, however, because many insurance policies, rightly or wrongly, may not cover it. Thus, it is not so clear that a full refund is the right answer.

Interestingly, for two of those shows, the theater refunded me the entire cost of the ticket. In effect, the theater bore the whole risk. But for the other show, the theater instead gave me a credit for a future performance. In effect, the risk was borne jointly by myself and the theater.

In the last few days I have had another experience like this. I purchased tickets for a concert this summer; not surprisingly, it has been canceled. The organizer offered me three choices: Donate the cost of the tickets, get a credit for a future performance, or receive a full refund. I opted for the credit; that is, I agreed to share the risk with the organizer.

How is this dynamic playing out in pandemic-related contractual disputes that are unfolding now?

As you might guess, in a variety of ways. There is pending litigation involving a franchisor and franchisee in the theme park business, for example. The franchisee had invoked a force majeure clause in the contract when it argued that its obligation to make ongoing payments to the franchisor should be forgiven because the theme park had been shut down due to the pandemic and, explicitly, to comply with government shutdown orders. The franchisor argued that the force majeure clause did not apply because the franchisee’s payments were already overdue before the outbreak of the pandemic.

What is it that you find interesting about this dispute?

Several things. I don’t know the details of the franchise agreement or the extent to which there may be a legitimate disagreement about the terms. To the extent there is, the parties can rely on the courts to “complete the contract” and determine how the terms should be interpreted. But the facts here suggest that a renegotiation may be the most economically efficient outcome, and I would not be surprised if renegotiation were to prevail.

It may be that the ongoing payments required of the franchisee are impractical, or even impossible. Complying with a payment term may force the franchisee into bankruptcy. But bankruptcy may be an inefficient outcome, as it would require the franchisor to seek out a new franchisee. And that new franchisee would likely incur investment costs duplicative to those already incurred by the existing franchisee.

This gets us back to the concept of relationship-specific investments that are common in long-term relationships. These investments would be destroyed if the franchisor switched franchisees, which implies that ending the relationship may not be costless to the franchisor. So even though the terms of the franchise agreement might mandate specific payments from the franchisee, those payments might be “too good” for the franchisor.

This is not altogether different from homeowners who cannot make their mortgage payments. Banks can foreclose on homes, but there are transaction costs associated with doing so. Relaxing late penalties is one form of renegotiation.

But if the economic effect of the coronavirus pandemic is long-lasting, I would expect more in the way of renegotiation – for example, in the form of payment concessions. The reason behind this is that widespread foreclosures would be an even less attractive alternative if home prices fall systematically.

It is also conceivable, by the way, that it is efficient for the theme park franchisor to force the franchisee into bankruptcy and for banks to foreclose on specific mortgages. It may be the case that the outlook for the franchisee or individual homeowners has been so disrupted that it is more efficient to have a new franchisee or to sell the homes to people who can better afford them.

Could you see this kind of dynamic playing out in other kinds of economic relationships – say, between lenders and business borrowers?

Absolutely. Under what circumstances should a lender extend forbearance to a borrower if the latter is unable to make the obligated payments on the loan? To what extent will the long-term relationship (if any) between those parties affect the incentives and costs of forcing a borrower into bankruptcy versus extending or forgiving the loan? Determining the optimal strategy in these disputes will of course depend on the specific facts of each dispute, but contract theory can be helpful in determining how to think about that strategy.

As a final point, let me note that if the inevitable incompleteness of contracts is recognized from the outset, it’s possible to build guiding principles for renegotiation right into the contract. That way, in the presence of unforeseen contingencies, the parties agree to be equitable, among other things, in filling in the gaps as they arise.

In thinking about this new approach to contracts, my colleagues David Frydlinger and Kate Vitasek and I have labeled it the vested methodology, because each party in the contract then has a vested interest in the success of the other. We’ve seen a number of businesses already adopting this approach, and we will be interested in seeing how such contracts might make it easier to navigate massive shocks to the system such as the pandemic. ■