Contract Design and Shading Problem

A SEMINAR REPORT SUBMITTED TO

RAJIV GANDHI SCHOOL OF INTELLECTUAL PROPERTY LAW

IIT KHARAGPUR

AS PER COURSE REQUIREMENT

FOR THE DEGREE

LL.B. WITH HONOURS IN IPR

SUBMITTED BY

Abhishek Sinsinwar

15IP61037

LL.B IVth SEMESTER

UNDER THE GUIDANCE OF

Prof Arindam Basu

27th February, 2017

1
 DECLARATION

This is to certify that the present seminar paper entitled Contract Design and Shading
Problem embodies the original research work carried out by Abhishek Sinsinwar under my
supervision and guidance. This work is forwarded to Rajiv Gandhi School of Intellectual
Property Law for evaluation.

..........................................
Seminar in charge

Dr Uday Shankar
Assistant Professor
Rajiv Gandhi School of Intellectual Property Law,
IIT Kharagpur.

Supervisor

Prof Arindam Basu

Assistant Professor

Rajiv Gandhi School of Intellectual Property Law,

IIT Kharagpur.

2
Table of Contents

Introduction......................................................................................................................................4
Breach of Contract and Contract Design:........................................................................................5
Shading............................................................................................................................................6
Courts Approach.............................................................................................................................7
Contract Design...............................................................................................................................8
When Uncertainty is Low and the Market is Thin: The Case of the Complete Contingent
Contract............................................................................................................................................9
Bilateral Contracting Under Moderate Uncertainty: The Case of Rules and Standards...............10
Bilateral Contracting with High Uncertainty: The Case of Collaborative Agreements.................11
Thick Markets and Low Uncertainty: The Case of Trade Associations........................................12
Thick Markets and Higher Uncertainty: The Case of Expert Courts............................................13
Conclusion.....................................................................................................................................14

3
Introduction
Contract Design is the way to address issues which came due to contractual obligations. The
Behavioral aspects of contracts which includes problems of cooperation and opportunistic
behavior are the one which are most unaddressed. Despite recent advances in the understanding
of contracting behavior, the economic contract theory is not able to identify the principal causes
and effects of contract breach.

A novel variation on opportunism which is called as Shading is used here to identify various
issues due to lack of proper contract design.

Contracts laid certain obligations to the parties which are part of such contract. These contracts
are Tailor Made' means as per demands of market and risk associated with the certain act. It has
been observed that in cases of contract breach current theories of Economic contract theories are
failed to explain adequately the causes and effects of such breach.

The breach which is ex post in nature, how can we adjust it through the contract to ex ante?

This question can be addressed by using unique characteristics of the contracts. Interpretation of
contract is the single most source of commercial litigation and which is least settled. It remains
always a contentious area of contemporary contract doctrine.

Courts are with the responsibility to provide such interpretation to contract in a commercial
litigation but they are not able to inquire into the behavioral approach of contracts and restrict
themselves to mere paper of contract. They only go after the text while left the context behind so
opportunistic behavior in whatever form and by whatever party is very difficult to discover during
the litigation process. Hence, the ultimate design goal is to avoid handing a generalist court an
interpretive task that the court is unlikely to be able to perform successfully.

To curb opportunistic shading in contract adjudication we need to include certain prospects of

market behavior and customs into the contract. The design of contract should be done in a manner
that it can reduce the anticipated opportunism costs that are inherent in ex post adjudication of
breach of contract claims.

There are two crucial characteristics of the contracting environment that influence how these
parties design their contracts. The first is the level of uncertainty whether commercial practices
are stable and predictable, or, alternatively, are continuously disrupted by unforeseeable changes

4
in technical possibilities and market conditions. The higher the level of uncertainty, the more
difficult it is for parties to write complete, state-contingent contracts and the greater the challenge
for courts to interpret the parties

The second is the scope or scale of the market whether there are many traders or a few engaged in
a particular class of transaction using similar contracting strategies. The greater the number of
traders are engaged in a transaction, the more likely that the contractual regime terms adapted to
current need and a mechanism for adjusting terms as needs change will be provided by a
collective entity, such as a trade association and disputes arising under it are likely to be resolved
by a specialized arbitral body.

By deploying sophisticated design strategies tailored to these particular areas, parties are able to
reduce the risk of shading and to reduce the role of the decision maker tasked with policing this
difficult to verify behavior.

Breach of Contract and Contract Design:

The fundamental challenge for lawyers in designing a contract is that contractual obligations are
agreed when the contract is formed but are enforced after the transaction has broken down and
parties are litigating hence the contract design is the only area which can help to curb the breach.

The uncertainties of contract sometimes results in the dilemma of contract as the party who is
disappointed by the after events may argue that the contract as written doesn't fully reflect the
parties true agreement and the party who was blessed by the contract may argue that the contract
is same as written what the parties intended even though it appears in hindsight to lead to
unreasonable results.

Anticipating this problem, the challenge for contract design is to choose between two very
different options-

(1) Expend additional drafting and negotiating costs to devise innovative contract terms that
reduce the likelihood of future strategic behavior , or

(2) Postpone costs and delegate discretion to a later court to find out and deter this strategic
behavior once litigation arises.

5
 But when the case comes to the situation that a conclusion reached by the court following a
trial in which both parties contended that their behavior was entirely proper under the contract.
These methods will not be effective to address them.

It can be of kind that a party miscalculated the kind of performance the contract requires or
one of the parties is welching on the deal.

In case of welching the deal, a party who is strategically doing it his behavior can be termed
as opportunism.

Here the person who is welching the deal is basically shading the truth hence he is shader
while the first one in doing it in a mistake.

So it is important to find out the shader from the former to give justice to the subject.

Shading
All contracts depends on courts to implement the ex ante instructions correctly that the parties
have embedded in their agreement.

These instructions can be framed either as "hard" terms i.e. precise, bright line rules or as
soft" terms i.e. broad standards or as combinations of the two. But whether hard or soft, one
party or the other will obtain a significant ex post advantage whenever there is a substantial
exogenous shock between the time of contracting and the time of performance. Thus, if the
contract terms are hard, the party with

the apparent benefit of a bright-line rule can extort rents by refusing to adjust its behavior in
ways that would reduce the ex post losses of the counterparty

that hard terms can work an injustice to the party who has been disadvantaged by fate, many
scholars have argued that courts should imply broad standards of reasonableness or good-faith
adjustment to moderate the effects of the bright-line obligation that subsequently proves so
vexing. But this strategy merely shifts the advantage to the counterparty. Substituting a soft
standard such as good faith adjustment for the hard rule merely creates a moral hazard risk on

6
 the other side, inviting a losing party to exploit the courts discretion by persuading it to
reallocate losses that were in fact allocated to the losing party by the contract.

Courts are need to make a Solo monic determination of who is the likely opportunistic party
and impose sanctions independently of what the contract appears to require on the basis of
shading provided in above two cases.

Courts Approach
In cases of shading usually the courts are prefer to deciding appeals from summary judgment
or motions to dismiss and did not address the issue of opportunistic behavior.

Also in matter of custom or trade related issues when courts are asked to identify a trade usage
they rely exclusively on interested party testimony rather than on a careful evaluation of
complex evidentiary submissions.

Because in enforcing contracts requires interpretation, which means that courts are asked to
police shading behavior, but doing so often leads to errors, because the courts are asked to do
more than they are able to do.

Courts are not the specialized agencies who can understand these matter in better way.

However courts have sometimes tried to address these issues. Courts have two systems to
judge the issue, first by civil law and second common law.

The shading problem was contained by virtue of the historic division of roles between law and
equity. The rules which in their objective terms are used to address the issue and which are
administered strictly cannot be a good system to address these issues. So here we can look for
the doctrines consisted largely of equitable principles to address these issues.

They were applied when in the ordinary course of law failed to provide justice. Hence they
were usually cast in subjective terms of contract and therefore it needed judges to exercise
judgment by weighing the fairness or the "equities" of the particular transaction.

However this system cant not only address this issue as they contains the interpretive rules of
objective laws only and every time it is not possible to court to address these issues in
particular manner. Hence commercial parties today are likely to be poorly served if they
choose to rely on subjective, equitable review by contemporary courts.

7
 Also lacking of requisite specialization, courts are ineffective at uncovering the underlying
context that is essential if they are to police opportunism effectively.

In case of Central Bank of India Ltd. Vs. Hartford Fire Insurance Co. Ltd 1. The apex court
went for contract at will approach as the person whose insured goods were destroyed in riots
was not paid as he was not able to empty his go down as per banks instructions.

Also in case of M.R. Engineers and Contractors Pvt. Ltd. Vs. Som Datt Builders Ltd 2, in
absence of contract the court refuses to provide equitable remedy by appointing arbitrator. It
was held that application of sub-contractor should be rejected on ground that arbitration clause
were exist in main contract and not incorporated by reference in sub-contract.

However In Champaklal v. Nectar Tea Co3, Rangnekar J. Held that where a person agrees to
employ another as his agent, moneys paid by the agent as a deposit, impliedly mean that it is
security for a completion of the contract and a guarantee of good behavior and faithful
performance of the obligation of the party making the deposit under the contract, and the
moment the agreement is broken there is either failure of consideration or there is an equity in
favor of the agent which impliedly makes the retention of the sum of the deposit a debt due by
the employer to the agent. The rule that the debtor must find his creditor applies and the agent
can bring a suit where he resides and provide equitable remedy to the respondent.

Contract Design
The best method to curb the shading is abandon the ex post question that asks what contract
doctrines best help courts determine when to intervene to deter opportunism instead we need
to work on ex ante perspective that how can we design a contract that appropriately limits the
risk of opportunism and thus properly confines the courts role in supervising the contracting
process.

The first method is customization or tailoring of familiar contractual formulations. It

involves changes in the terms within a particular instrument to address particular uncertainties
with future states. As by using the words such as best efforts, reasonable best efforts or

1
AIR1965SC1288
2
2010(6)ALT17(SC)
3
AIR 1933 Bom 179
8
 commercially reasonable efforts as modifiers that are combined with specific or precise
performance obligations under the contract to curb this issue by providing a tortious
obligation.

However it alone cannot be able to curb this in the era of Information revolution as the
contracts and their terms are innovating day by day.

The level of uncertainty is more and which cannot be only addressed by using of these terms.
The higher the level of uncertainty, the more difficult it is for parties to write, and courts to
interpret, completely specified and fully integrated contracts.

Contract Design can be done in various modes subjected to Market scale and uncertainty
level-

When Uncertainty is Low and the Market is thin: The Case of the Complete Contingent Contract

Uncertainty and scale together determine whether and how the contract in question deals
successfully with the shading problem.

In the case of thin markets where the key variable is the level of uncertainty, contract
design occurs primarily in bilateral relationships. The level of uncertainty will determine
how the parties respond to the problem of shading.

When uncertainty is low, parties can turn to customized, completely specified contracting.
By incorporating any context thought to be relevant as part of the terms of a complete,
formal agreement they can specify precisely the evidentiary base that will be made
available to a court while still preserving the courts historic role in policing opportunism.

Also the parties can specify in the agreement that the meaning of terms should be
interpreted according to the customs and norms of a particular industry or commercial
community. This additional context can supplement precise specifications of outcomes
while still constraining a future courts discretion to range more widely than the parties
want ex ante.

9
 The point is here that low uncertainty permits parties to design a contract that reduces the
need for courts to inquire into any evidence extrinsic to the written agreement. By
reducing the burden on a court to characterize ex post shading behavior accurately, a
relatively complete contingent contract also reduces the likelihood of a court making a
mistake in interpreting the contracts terms. It reduces the incentive for the party
disfavored by subsequent events who is the likely shader to engage in opportunistic
litigation in the first place.

Bilateral Contracting Under Moderate Uncertainty: The Case of Rules and Standards

When the contracting parties confront moderate levels of uncertainty in the sense that they
can identify what should happen in some but not every future state of the world, the
parties are require to use commercially reasonable or best efforts kind of words to
accomplish the specified tasks, reflecting the fact that the appropriate strategy is
dependent on the outcome of uncertain events, such as the market demand and competitive
conditions for the product in the first example and the results of clinical tests and the
course of the regulatory process in the second. The reason to use standards is that courts
assess performance with respect to standards only after the relevant future events have
occurred.

In this way, parties can obtain the advantage of hindsight and the court has information
once the dispute arises that the parties lacked at the time of drafting the contract. In this
intermediate range of uncertainty, sophisticated parties use design strategies to constrain
the discretion of a court to address the behavioral aspects of parties. Here specific
obligations can be put in terms of contract to meet the best efforts standard. The specific
obligations are directions about the context through which the standard should be applied.
By combining specific terms with generalized obligations the parties can add context
evidence that is revealed over the course of contract performance to the original text of the
agreement. The more effectively this context evidence can be harnessed so as to limit the
courts discretion in applying the relevant standard, the more attractive is the use of
standards that take advantage of the courts hindsight advantage.

10
 Hence where the level of uncertainty calls for the use of standards, it is the parties and not
the courts that choose the balance between text and context that best suits the level and
kind of uncertainty the transaction protects.

Bilateral Contracting with High Uncertainty: The Case of Collaborative Agreements

As the level of uncertainty rises even higher, commercial parties can no longer rely on the
traditional forms of contracting. This high uncertainty environment, where an entirely new
technology can disrupt the status quo, has triggered a revolution in the basic form of the
contract.

Even though there is a formal and very detailed contract of many terms and pages, the
contract regulates only the commitment to collaborate, and not the course or the outcome
of the collaboration which is left entirely unspecified. That means any effort to enforce
this agreement in court is limited to protecting each partys promised investment in the
collaborative process rather than directing a division of any surplus that might result if the
collaboration were to succeed.

Trust and confidence are extremely valuable commodities in these kind of contracts. Not
only do they motivate each party to invest in the relationship but they also make the
prospect of abandoning the relationship in order to collaborate with others much less
attractive.

The governance of these commercial collaborations shares several common elements. The
first element is a commitment to an ongoing mutual exchange of private information
designed to determine if a project is feasible, and if so, how best to implement the parties
joint objectives. The second component is a procedure for resolving disputes. Its key
feature is a requirement that the collaborators reach unanimous agreement on crucial
decisions, with persistent disagreement resolved by unanimous agreement at higher levels
of management from each firm.

Together these two mechanisms make each partys character traits and substantive
capabilities observable and forestall misunderstandings. Working under conditions of
uncertainty, the parties can expect to encounter unanticipated problems that can only be
solved jointly and that may generate occasions of disagreement. Their increasing

11
 knowledge of each others capacities and willingness to share private information in
service of their collective goals facilitates the resolution of problems and constrains
opportunistic behavior. The limited legal commitment contemplated by collaborative
contracting means that there is a significant constraint on the potential role of a court
charged with policing shading.

Thick Markets and Low Uncertainty: The Case of Trade Associations

The scale of the market changes the landscape of contract design. As the greater the
number of traders engaged in the same kind of a transaction, the more likely that the
contracting infrastructure will be provided jointly as an industry specific public good by a
trade association.

In such a case, the contract designs are institutionalized outside the participating firms and
arise when markets are thick many contracting parties are affected by the same exogenous
event or, even in the absence of such an event, many parties are acting in the same
commercial environment.

For key commodities like grain, cotton. Here we encounter a thick market where many
parties engage in the same or similar forms of contracting. When markets are thick, the
costs of design can be spread in the sense that many actors face similar risks and stand to
benefit from concerted responses to them. In this environment, the affected parties often
institutionalize their contract design through collective action. Once again, the design
challenge will vary according to the level of uncertainty faced by the actors, but scaling
the contractual product permits novel solutions to the shading problem.

Regarding the courts approach in these kind of contracts, the generalist judge can't be
expected to have knowledge of such embedded trade practices and customs so it is in
doubt that he be able to conveniently obtain the information needed to make an accurate
determination of which party is the shader. So the trade association in this situation has to
cope with the adverse consequences of judicial ignorance while, at the same time, creating
a framework to reduce the risk of shading. This challenge motivates the trade association
to engage in innovative design. Many of these trade groups have chosen to rely on expert

12
 arbitrators to strictly enforce industry approved, standardized contract terms. The parties
regularly update the terms to keep them current with practice as it evolves.

Thick Markets and Higher Uncertainty: The Case of Expert Courts

Where there are a large number of highly complex transactions that share general features,
but where each transaction has significant idiosyncrasies, and the common background
conditions shift rapidly, the specialized courts come into play to address these issues.

The thick market enables a corporation to mitigate the shading problem by incorporating
in a jurisdiction that has sufficient scale of incorporations that its judges develop the
necessary experience and expertise.

In this case, the uncertainty stems from the strategic interaction of the various corporate
actors intent on manipulating open-ended rules in volatile environments to advance their
private interests. On the one hand, the parties know the general rules that apply, but also
know that the counterparty will seek to exploit those rules to its advantage. To the extent
that actors in such an environment take collective action to reduce the chance of judicial
error in ex post application of standards like fiduciary duty, they are able to rely on expert
judges with significant experience in the field; to rely, that is, on a specialized court of
equity. The specialization of the court and its equitable powers assure parties that, despite
the impossibility of codifying decision rules, judicial decisions will be taken with the
fullest possible awareness of current understandings of good practice, that is, the court can
with reasonable accuracy assess the context because it is part of it.

A match between local courts and local industry provides an effective legal infrastructure
for an industrial district, the generalist court acquires the expertise to well serve its
litigants in this regard, it becomes a specialist. Under certain conditions, therefore, parties
use their scale to invest a particular court with expertise in discovering the relevant
context. Courts in these areas can over time develop both judicial expertise in the subject
matter of contracts and a body of precedents that can parallel the private interpretive
regime created by trade associations.

13
 In India, the President of India in January 2016 granted his assent to the Commercial
Courts Act that will witness the establishment of commercial courts at a district level and
commercial divisions and appellate divisions at the High Court level. The reforms ushered
in by this legislation seek to completely transform the manner in which commercial cases
are heard and tried in India. They include the establishment of specialised courts to deal
with commercial disputes above a specified value, a strong emphasis on judicial efficiency
through case management and an uncompromising stance towards time bound resolution
of cases and appeals. Modern measures such as electronic filing and videoconferencing
will be rolled out. Under this dispensation, unnecessary adjournments are frowned upon
o
and strict timelines have been set, reinforced by lim itations on courts' discreti n to condone
4
delays..

Conclusion

In our preceding discussion, we discussed many variations in contract design where

commercial parties have sought to mark out the courts role in the interpretive process.
The central idea is that the level of uncertainty and the thickness of the relevant market
will determine the range of design strategies that are found in contemporary commercial
transactions. In each of these cases a primary objective is to design a contract that meshes
with the relational or informal enforcement that the context provides and thereby serves to
cabin the role of the decision maker tasked with policing difficult to verify shading
behavior. Contracting parties must be able to count on the state's enforcement monopoly if
they are confident to rely on the novel forms of agreement afforded by the relevant design
space. Ideally, generalist courts should respond to novel contract designs by enforcing the
chosen methods of mutual cooperation on terms consistent with the arrangements
themselves. A court's ability to achieve this consistency will depend very generally on

(a) Its expertise in the domain of the contract,

4
https://www.law.ox.ac.uk
14
(b) the conspicuousness of the particular contractual regime (i.e., the salience of the
industry codes or other markers that indicate to outsiders that insiders have given
distinctive meaning and effect to strategies for coping with shading), and

(c) The extent to which the court respects the purposes and values to which the regime is
dedicated.

The role of generalist courts thus will differ across the various dimensions, but in all
events, it will be more restricted than the standard account under which the court is
supposed to fit quite different forms of contracting into the traditional doctrinal categories
of common law contract. . If a central goal of contract adjudication is to enforce the
contract that the parties have provided, then the courts need to accept the role that the
parties have given them.

Specialised Commercial courts are not a novel phenomenon and exist in countries such as
the United Kingdom. For cross-border disputes, newer destinations such as the Singapore
International Commercial Court and the Dubai International Financial Centre Courts have
gathered momentum. The structure, functioning and experience of these institutions could
offer suitable models for implementation of commercial courts in India. Of course,
adaptions would be required to suit the specific circumstances prevalent locally.

Hence judicial reforms must continue to be at the forefront of the Indian Government's
priority to pursue its goal of "Make in India", it must also endeavor to "make cases heard
in India" by stemming the flood of exported litigation in commercial litigation.

15
16