Incompleteness Theory of Contracts and Smart Contracts
Even with the supposed benefits of smart contracts, the fundamental tensions inherent to liberal, free-market contractual agreements are still present. The incompleteness theory of modern contracts was pioneered by Nobel Prize winner Oliver Hart and seeks to understand why firms exist at all—or more precisely, why one firm would decide to buy another instead of entering into a contract. This theory operates on the assumption that contractual parties operate to maximize individual profit rather than the common surplus for all entrants. As such, Hart claims that the ubiquity of contracts is in part due to their intrinsic incompleteness which permits opportunistic profit-maximizing behavior. This incompleteness is generated due to the impossibility of foreseeing every potential contingency that may occur, and though moral hazard or asymmetric information may encourage the compliance of contracting parties, there are often ambiguities or inconsistencies that may produce conflict.
The inability to account for all contingencies creates an imbalance in contract creation wherein the chief question becomes which provisions or contingencies the contract will consider. This ability to determine what the contract will omit via its incompleteness are called “residual control” or “decision rights.” 3 Hart argues that these decision rights can dictate contract negotiations in substantial ways—by generating holdups and opportunistic behavior, for example. A holdup is when one party that has entered into a contractual agreement becomes dependent in some way on the other party—for example, superior supplier relationships have granted the latter party a monopoly on local prices—and has to renegotiate their contract. 4 The latter party can hold up the former by pushing for more favorable contractual conditions for themselves due to their heightened bargaining power. Hart suggests that these issues be avoided by more precise due diligence on behalf of the former firm or the expansion of their property to include their supplier relationships—in other words, vertical integration. This process weakens the residual rights of the former firm as their contractual bargaining power is reduced, exemplifying one reason why contractual provisions are often capacious and dynamic—to account for codified control, exit, and residual rights between firms as future states of commerce are uncertain. For example, suppliers may intentionally provide sunset provisions, exclusive supplier rights, or rigid timeframes to ensure that exogenous shocks or production innovations don’t threaten their margins beyond a quasi-predictable window. This potentially reduces the efficiency of market transactions as some refiners are forced to adhere to contractual agreements that are no longer favorable compared to new entrants or competitive innovations in the supplier market.
Aside from commodity transactions, capital investment and equity structures also suffer from similar incompleteness-driven pitfalls. Supporting these claims are studies stemming from the field of firm financing, largely driven by empirical studies of entrepreneurship and small businesses. The perception that small businesses are the backbone of the economy has served as the foundation of many empirical and theoretical inquiries related to equity, ownership, and incomplete contracts. Consequently, a growing body of literature has appraised the efficacy of government policies aiming to stimulate entrepreneurship, the contractual constraints guiding venture capital (VC) funding, as well as the efficacy of internal vs external financing. 5 Both internal and external financing are susceptible to similar drawbacks regarding contracting for innovation and the ownership of non-pecuniary investment proceeds. Interfirm financing between VC’s or individual investors and firms is shaped in many ways by the incompleteness of contracts as financing provisions increasingly include considerations for control rights, exit clauses, and convertible securities, such as preferred stock, to maximize the opportunism of the contractual entrants. 6 This allows investors greater latitude to control the opportunistic behavior of the firms they contract with via investing. For example, investors may want to set the salaries of managers or determine which products a plant produces in the future which can be difficult changes to institute without formal contractual codification of these rights via equity or board membership. 7
This doesn’t only have implications for interfirm transactions; intrafirm financing requires contracting as well. Aghion and Tirole have highlighted the issues internal R&D programs encounter related to the ownership rights of innovation as technological developments deviate from the expected outcomes outlined in the contract. 8 Others have investigated the contractual obligations of government subsidies and the internal distribution of these funds to understand how contract structures may influence firm productivity over time. 9 Hart has extended this theoretical consideration to the state, arguing, for example, that the state’s incomplete contracting with private prison providers allows these firms to leverage invidious residual control rights. Hart, Shleifer, and Vishny claim that these public/private prison contracts fail to outline provisions for the use of force and qualifications of personnel which permits exploitation on the part of private firms—e.g., permitting excessive force. Hart outlines the critical differences between public and private contracting provisions but emphasizes that the issue is not the private/public character of the contract. Rather, these contracts are vulnerable by dint of their incompleteness which fails to account for all the possible future states of the world—e.g., prices of commodities or prisoner inflow volumes. This information asymmetry risks opportunism as contractual entrants with greater access to innovative insights or exogenous shocks to supply chains—e.g., suppliers in our simplified example—may be inclined to execute/delay provisions based on asymmetric market insights.
A critical motivating factor underlying these contractual vulnerabilities is the uncertainty of future states of the world given the execution time of current contracts. According to Hart, “if one is prepared to assume that…the parties can always negotiate the contract…because there is no clear deadline, then the incomplete contracting story, and the role for asset ownership, can be resurrected.” If parties could be certain of the state of the world when a given contractual provision executes, e.g., the sale of goods at a pre-established price or the necessary qualifications of staffed personnel, then it is possible that some of the incompleteness driven issues can be mitigated. As such, industry members and academics alike have turned to instantaneously executing contractual mechanisms to mitigate the risk implicit in future based uncertainty. Many believe that the more immediate execution of transactions and managerial decisions will reduce firm inefficiencies and the implied risk of business interactions. Concomitantly, the potential for instantaneously executing provisions has been explored for sectors from insurance, 10 commodity distribution, and financial and real estate transfers. 11 Scholars have argued that the incompleteness intrinsic to mutual will theories of contract can be greatly reduced by “codification” via various executing instruments—e.g. smart contracts. 12
From a high level, a smart contract is a programmed execution mechanism within a traditional contractual provision and is often attributed to Nick Szabo’s 1994 working papers. 13 The synthesis of these smart contractual provisions with distributed peer-to-peer ledgers on the blockchain has generated excitement for the possibility of a more secure, anonymous, and transparent contracting environment. When a smart contract is deployed on the blockchain it is possible for it to confirm the states of its various provisions automatically and instantaneously via blockchain records—e.g., the sending or receipt of payment via digital wallets—without the confirmation of a third party. By no longer requiring a third party, the smart contract model potentially streamlines the process of transacting by reducing the need for legal or compliance related oversight. Though these are digitally rendered mechanisms, they can be upended to contractual provisions of all kinds and thus impact a broad range of commodity/service and equity/financing related issues of transacting.
Though there exists a burgeoning literature accounting for the ascendance of smart contracts, Hart himself was ambivalent to their potential to rectify the myriad issues implicit in modern contracting. 14 However, Lorne et. al. are quick to point out that Hart recently joined a blockchain company as an advisor to their smart contract programs. 15 Other scholars have demonstrated cautious optimism related to the adoption of smart contracts as a remedy to incompleteness derived issues. Holden and Malani authored one of the first investigations linking Hart’s incompleteness theory to emerging smart contract technologies to appraise their efficacy as a solution to the holdup issue in particular. Barrera and Hurder have emphasized the ability for smart contracts to encourage the creation of shared consortiums and databases by reducing the holdup effect between firms. 16 Meier and Sannajust’s 2020, “The Smart Contract Revolution: A Solution for the Holdup Problem?” assert that smart contracts are valuable for stimulating digital and financial transactions but posses unique vulnerabilities for small firms engaging transacting in physical commodities. Their study is one of the first attempts to model the economic impact of smart contracts and emphasizes their potential to reduce opportunistic behaviors committed after the creation of a contract. 17
The strengths of smart contracts have been championed beyond their ability to address holdup issues. Zheng et. al. have provided a framework that summarizes the advantages of smart contracts over conventional contractual agreements in three areas: risk mitigation, reduced operational overhead, and more efficient business operations. These benefits are distributed across the various procedural phases of smart contract application, creation, deployment, execution, and completion. 18 In application, these smart contracts streamline escrow processes by freezing associated digital wallets pending execution and completion of contractual provisions which further minimizes the third-party influence on transactions. Moreover, the transparency of the blockchain ledger and oracle from which chains derive their data enhances the fidelity of the smart contract system by minimizing data asymmetries and reducing the contingencies of ex post facto negotiations, disputes, etc.
The drawbacks of these smart contracts have been well documented by Hart, Zheng et. al., and Meier & Sannajust. Just as issues with traditional contracts are solved with the introduction of smart contractual technologies, new transactional issues have arisen to accompany this adoption. These two issues revolve primarily around issues of resource intensiveness and trust. The issue of resource intensiveness is perhaps the most fundamental hurdle confronting the widespread adoption of smart contract technologies. Smart contracts require a digital infrastructure to operate which concomitantly requires an entire operational network of peer to peer nodes available to confirm transactions and act as authorities for contractual provisions. Meier & Sunnajust argue that due to these heightened intrinsic costs of contract deployment, small entrepreneurial firms will be less incentivized to implement smart contracts; however, this caveat only applies to small firms delivering physical commodities as largely digital sectors retain the benefits of smart contracts. 19
The issue of trust is almost as important as that of resource allocation because smart contracts instantaneously execute major contractual obligations based on third party data from oracles and other databases. Oracles are data aggregation networks built on the blockchain but integrate existing web 2.0 data sources to provide information about real world events—e.g., market prices or delivery completions. Bettors on EuroBet, for example, are relying on a proprietary oracle to provide live event information vis-à-vis sport outcomes, and, as such, it is crucial that the source of that data is trustworthy. Some have argued that smart contracts should implement machine learning and artificial intelligence-based algorithms to develop and refine a trustworthy third-party oracle. Notwithstanding the potential idealism manifest in this proposal, even if an industry standard, trustworthy oracle was established—one that distributed information equally and resisted tampering—the issues implicit to smart contract technology would largely remain. One of the most prominent issues inherent to smart contracts deployed on the block chain is their rigidity—once they are deployed, it is very difficult to change them. As such, it can be very cost intensive to develop, test, refine, and finally ensure the seamless implementation of these contracts.
Unified models have been created to help disseminate standard smart contract frameworks with many scholars advocating for the critical application of what are called “wise contracts” instead of smart contracts. 20 In any case, it is clear that like many of the transformations to the financial sector that accompanied the transition to the digital age, the smart contract can be leveraged to make business more efficient. By alleviating some of the incompleteness driven frictions intrinsic to traditional contracts, the distributed ledger system provided by the blockchain has already begun reshaping our contracting environment. Nonetheless, we must approach these contracts with caution as they may only benefit certain firms and require heightened expertise to deploy properly.
References
1 (Horwitz, 1977, pp. 173-174)
2 (Chen, et al., 2018, p. 1410)
3 (Hart, 2017)
4 For case law establishing the real contractual vulnerability that holdups present see Alaska Packers Association v. Demenico, 117 F. 99 (9th Cir. 1902).
5 (Haltiwanger, Jarmin, & Miranda, 2013); (Kaplan & Stromberg, 2003); (Azoulay, Graff-Zivin, Li, & Sampat, 2019)
6 (Cornelli & Yosha, 2003)
7 (Hart, 2017, p. 1736)
8 (Aghion & Tirole, 1994)
9 (Lach, Neeman, & Schankerman, 2021)
10 (Borselli, 2020, p. 101)
11 (Zheng, et al., 2020, p. 2)
12 Hazard and Haapio have argued for the prudent broad-based adoption of “wise contracts” that would mitigate current contractual issues.
13 (Szabo, 1994); (Szabo, The Idea of Smart Contracts, 1997)
14 (Lorne, et al., 2018); (Green, 2018)
15 (Lorne, et al., 2018, p. 110)
16 (Barrera & Hurder, 2019)
17 (Meier & Sannajust, 2020, p. 1085)
18 (Zheng, et al., 2020, p. 5)
19 (Meier & Sannajust, 2020, p. 1084)
20 (Hazard & Haapio, 2017)
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