Designing Cost-Effective Litigation Through Contract Structure

Cathy Hwang is Associate Professor of Law at the University of Utah S.J. Quinney College of Law; and Matthew Jennejohn is Robert W. Barker Professor of Law at Brigham Young University, J. Reuben Clark Law School. This post is based on their recent paper.

Complex contract structures are well understood by practitioners, but they are almost entirely overlooked by scholars. In our new paper Deal Structure, we argue that contract drafters can use contract structure to their advantage. Careful crafting of contract structure can nudge courts toward interpretive methods that lower litigation costs.

Practitioners often understand that inattention to contract structure can have serious consequences. For instance, in a 2010 case between Hewlett Packard and Britain’s Sky Broadcasting, a trial lasting nearly one year was necessary to interpret an intricate outsourcing contract and several other agreements between the parties. The outcome of the case hinged, in part, on how several related provisions in the separate contracts were read together. In the end, the court issued a 468-page opinion and awarded a £200 million judgment.

Complex contract structures, however, are not nearly as well understood by scholars. For generations, scholars have been mired in a long-standing debate: Should a court take a textualist approach to contract interpretation, and stick to the four corners of a contract? Or should a court adopt a contextualist approach, and consider clues such as past practice, course of dealing, and industry norms to ascertain the parties’ true intent?

In recent years, new research has shown that structuring a particular provision as a rule or as a standard can nudge courts toward textualism or contextualism. In general, standard-like provisions nudge courts toward a contextualist approach to interpretation, and rule-like provisions nudge courts toward textualism. A material adverse change (MAC) clause in an acquisition agreement is a good example of how this works. It is drafted as a standard—that is, despite its length and complexity, there is surprisingly little clarity about what triggers a MAC. Thus, when a MAC is litigated, a court must necessarily look to context to interpret it.

That research also shows that, when properly deployed, each pairing—rules with textualism, standards with contextualism—can reduce litigation costs. For example, using a contractual rule makes the parties’ intent clear, which means that courts can interpret the contract using only its text. This allows parties to sidestep the expansive (and expensive) discovery that usually comes with a more contextualist approach. In some instances, however, a standard will actually be the cheaper choice overall. Standards allow parties to side-step the time-consuming and expensive process of drafting and negotiating a rule, which is a sensible cost-saving approach if the probability of litigating that provision is very low.

Our research builds on that prior scholarship, and shows that the ability to toggle between textualism and contextualism is entirely dependent on something that has been overlooked: a contract’s underlying structure. Existing scholarship assumes that contract provisions can be easily identified as a rule or a standard. This overlooks the fact that modern contracts are complex and interdependent, and that many provisions in the same contract—or even provisions in several related contracts—work together to allocate a risk. (In other work, we discuss this in more detail in the context of M&A deals—here, here, and here—and pharmaceutical alliances, here.) In fact, modern contract provisions are often so interactive that they are no longer strictly rules or strictly standards—and this complicates parties’ ability to toggle cleanly between textualism in contextualism.

In our paper, we provide a comprehensive account of structural complexity in modern contracts, and discuss paradigmatic examples of common contracting structures. In particular, we differentiate between modular contracts (where provisions are well-isolated from each other) and integrated contracts (where provisions are highly dependent on each other to work). We also show how contract scholars use modularity and integration to advance their contracting goals. Most importantly, we posit that in order to effectively toggle between cost-effective textualist or contextualist interpretations, contract drafters must be careful to embrace modular contract design. Only when provisions are reasonably well isolated from each other—and only when their connections to other provisions are easy to parse—can parties truly harness the cost-reducing benefits of using a rule or a standard.

The complete paper is available for download here.

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