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Unpublished Paper
Dividing the Surplus upon Termination: The Case of Relational Contracts
ExpressO (2009)
  • Ofer Grosskopf, Tel Aviv University

Relational contracts typically create value which survives the end of the contractual relationship. Married couples accumulate matrimonial property that remains valuable long after they had ceased to value each other. Employees perform tasks which still have value after they had moved on to another workplace. Agents and distributors develop the markets for the products they distribute, thus creating good-will that will outlast their commercial relationships with the manufacturers. In all such cases a similar question arises: how to distribute the value which survives after the contractual relationships had been dissolved? This paper aims to offer descriptive and normative insights into this dilemma. Descriptively, it argues that the way such allocation problems are dealt with in the common law world had been transformed considerably during the 20th century. Under classical contract law the value which survived after the termination of any contract (including relational contracts) was allocated according to the property rights of the parties upon termination, unless the parties agreed otherwise. In other words, the default rule, which the parties could modify at will, was that each party received his or her property at the end of the contractual relationships, without having to compensate the other party for any value that was added to that property during the contractual term. Today, in contrast, the allocation rules in common law jurisdictions for many long-term relational contracts is different. It is frequently based on either a just division of the surplus between the former contracting partners (e.g. in the case of marriage) or on monetary restitution of the fair value of the surplus (e.g. in the case of agency) or on compensations that are not based on the value of the surplus, but on some secure amount that is promised in advance (e.g. in the case of employment). Furthermore, the ability of the parties to deviate from the "default rule" has been considerably limited, and in some cases even forestalled, at least if the private arrangement provides less than some standard legal benchmark. My normative claims provide economic arguments that support the above transformation from a unitary property-based default rule to multiple division-based semi-mandatory rules. It offers first a possible justification to switching the default from property to division, by employing Ayers & Gertner concept of penalty-default rules. The party who expects benefit from a property based default rule is in most cases the more informed and sophisticated contractor (i.e., husband, manufacture, employer etc.). It is thus justified, according to the penalty-default theory, not to base the division of the surplus that would survive after the contract would be terminated (an issue which parties to long term contracts tend to avoid) on the method that he would prefer, but on a scheme that will make him negotiate an inefficient allocation. Given that justification for division-based default rule, the paper goes on to argue that partly limiting the parties' ability to contract-around the default rule is not necessarily inefficient. As long as the parties are able to choose between different contractual regimes, which allocate the risk for the value of the surplus according to their preference, they will be able to adapt the distribution to reflect the efficient mix of incentives and risk bearing. The fact that their choice is limited, in the sense that they must provide a certain minimum level of protection to the weak party, is thus not a reason to assume that they will not be able to efficiently regulate their contractual relationship.

  • Relational Contracts
Publication Date
August 31, 2009
Citation Information
Ofer Grosskopf. "Dividing the Surplus upon Termination: The Case of Relational Contracts" ExpressO (2009)
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