Contract theory identifies verifiability as a critical determinant of the incompleteness of contracts. Although verifiability refers to the cost of proving relevant facts to a court, very little scholarship connects explicitly the evidentiary process to the drafting of substantive contract terms. This paper begins to explore this relationship to provide a more rigorous explanation of contract design. In particular, the paper concerns the very core of verifiability – truth-finding by a court -- and examines the impact of the prospect of evidence fabrication on contracting. It thereby also explores the puzzling tolerance of the adjudicatory system for fabrication and the incentives to fabricate created by thresholds in burdens of proof. The paper suggests that, despite undermining truth finding, evidence fabrication may be harnessed by contracting parties to improve the (evidentiary) cost-efficiency of performance incentives in their relationship. We divide the future into evidentiary states. In each state, nature produces evidence of breach by the promisor; in the zero state, nature produces no evidence of breach. The probability of each positive state is greater if the promisor actually breaches (q) than if she performs (p). In each positive state, the prospect of damages liability has two effects: it induces the promisee to spend resources to present evidence (truthful or fabricated) to secure a damages award and it gives a performance incentive to the promisor (who wishes to reduce the probability of that state). At the time of contracting, the parties view these prospects in expected value terms: (i) the deterrence effect from the expected cost of breach and (ii) the expected evidentiary cost. The parties contracting objective is to maximize across states the performance incentive bang at lowest cost. They may arbitrage across states to get the largest incentive bang for their evidentiary buck: selecting for states with high incentive bang (high q-p) at low expected evidentiary cost (low q,p). As a particular instance of arbitrage, we show that when the likelihood ratio (q/p) increases as the evidentiary state becomes large, the parties may wish to induce less evidentiary presentment in low states and more in higher states. This may involve evidence fabrication at higher states once all the truthful evidence is presented. In this way, the parties engage in a joint, conscious contracting strategy to mislead the court in some future evidentiary states of the world.
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Paper provided by EconWPA in its series Law and Economics with number
0403007.
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