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And the Nobel Prize Goes to... Contract Drafters?

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By Casey C. Sullivan, Esq. on October 11, 2016 12:59 PM

When we think of Nobel Prize winners, we tend to think of astrophysicists and chemists, poets and peacemakers, but rarely legal professionals. There is, after all, no Nobel Prize for law.

But the legal industry got some special recognition from the Nobel committee yesterday, as the Royal Swedish Academy of Sciences awarded the Nobel Prize for Economic Sciences to Oliver Hart and Bengt Holmstrom "for their contributions to contract theory." That's right, better contracts won the Nobel Prize.

What, Did They Rework the Rule Against Perpetuities?

Alright, so Hart and Holmström aren't exactly lawyers. They're economists with Harvard and MIT, respectively. But their work on contract theory has obvious implications for the law.

"Modern economies are held together by innumerable contracts," the Academy said when announcing the prize -- words bound to be repeated in 1L Contracts courses throughout the country today. Hart and Holmström's "analysis of optimal contractual arrangements lays an intellectual foundation for designing policies and institutions in many areas, from bankruptcy legislation to political constitutions."

Holmström's work, for example, focuses on employment contracts and the optimal relationship between performance and pay. He developed an "informativeness principle" to explain how an employee's pay should be tied to "performance-relevant information" while weighing risk against incentives. Holmström's later work expanded on that idea, noting that other incentives, such as the opportunity for advancement, can play an important role in the optimal contract.

Hart's work deals with "incomplete contracts," or the idea that (as every lawyer knows) it is impossible for a contract to account for every possibility. Hart's work, then, focuses on "control rights," or who should be entitled to make decisions when the unexpected occurs. "Hart's findings on incomplete contracts have shed new light on the ownership and control of businesses and have had a vast impact on several fields of economics, as well as political science and law," according to the Academy.

Relevant for Lawyers?

Most lawyers aren't particularly fluent in economic theory, but their insights do have value in attorneys' everyday practice. For example, lawyers have long known that a contract can't account for every possible outcome or contingency. That idea is reflected in a 1986 paper the two men wrote together. They found that "contracts are generally much simpler than theory might predict," according to the New York Times, and concluded that "specific instructions can be counterproductive, encouraging too much focus on what happens to be easily quantified."

Their research has even influenced IRS enforcement actions, the Times reports. In a case against Black & Decker and Wells Fargo, where the companies had spun off some of their business, the government relied on Hart's theories to argue that "that companies retained control of decision-making, and therefore they could not simultaneously lay claim to the cost savings."

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