Private Law Theory

ABSTRACT
For long-term commercial contracts, modification tends to be the norm rather than the exception. While modification often takes place in response to an arrival of new information, contracting parties frequently modify the terms in response to a shift in bargaining power. In this paper, we explain how the flexibility to renegotiate in response to a shift in bargaining power can facilitate long-term contracting and thereby beneficial reliance investments and risk allocation. The prospect of modification can induce contracting parties who expect their bargaining power to improve, such as from the emergence of outside opportunities, to enter into contracts earlier and realize the advantages of longer-term relationships. Otherwise, those parties might decline to contract or delay until those opportunities realize, thereby foregoing the benefits of long-term risk allocation or reliance investments. These parties’ private incentives to either forgo or delay a contractual relationship diverge from the joint interest in maximizing the contracting surplus. In examining this phenomenon, we address an important decision variable in the contract life cycle: the parties decide not only whether, but also when, to make legally binding commitments to each other. This timing question is, not surprisingly, a function of the path of information revelation and should be incorporated into the efficient balancing of commitment and flexibility in a transactional life cycle.

From the contract doctrine perspective, the paper argues that courts should be more lenient than they currently are in enforcing contract modifications that, prompted by a shift in bargaining power, may have only a redistributive effect. At the same time, the parties and courts should continue to be mindful that modifications can undermine the contracting objectives of protecting reliance investments and risk allocation. To pursue the balance between transactional efficiency and ex ante investment or risk allocation efficiency, we demonstrate how the parties can design under-compensatory damages that would provide a credible threat of breach ex post to facilitate ex post modification. At the same time, a complementary mechanism of requiring good faith in modification (along with damages) can constrain possible holdup and protect reliance investments and risk allocation. This explains why long-term commercial contracts often contain under-compensatory damages while requiring good faith in modification.

Choi, Albert H and Triantis, George G, Designing Contract Modification (February 2, 2025). Forthcoming in University of Chicago Law Review; University of Michigan Law & Econ Research Paper No 24-044.