Contract Innovation and Collaborative Contract Design

Date October 23, 2008
Speaker George TRIANTIS(Eli Goldston Professor of Law, Harvard Law School)
Commentator SHISHIDO Zenichi(Faculty Fellow, RIETI / Professor, Seikei Law School, Seikei University)
Moderator HOSHINO Mitsuhide(Director of Research, RIETI)


What must be understood before discussing contracts is that a contract is a product. For example, an insurance policy is a set of contractual rights that a customer has against the insurance company in the event that a contingency materializes. A bilateral contract is also a product. For example, when buying a car, the warranty is as much a part of the purchase as the physical automobile. The car company has an incentive to innovate in contractual terms just as it does the vehicle itself. Customers will pay more for a better warranty or a better delivery time in the same way as they would for better brakes or a more powerful engine. It is advantageous for a seller to add provisions to a contract that produce more value for the customer than what it costs the seller. Contract innovation can thus lead to greater profits.

The area in which contract innovation is most active and most apparent is financial innovation. Overall, contract innovation has several motivating forces, or shocks. One category is technology or learning. When technology improves, it creates opportunities for profitable innovation of contracts. A second category is market changes. Volatility tends to create opportunities for valuable innovation. New types of contracts appear to permit people to hedge, transfer, and distribute their risks. The third category is regulation. Parties are motivated to innovate in an attempt to avoid regulations or to comply with regulations.

A fourth driver of innovation, not commonly identified in the literature on the subject, is anticipation of litigation. The possibility, costs, and repercussions of litigation are taken into consideration by attorneys when designing contracts. Litigation that interprets a term of a contract in a slightly different and unexpected way creates the need to revise the terms of the contract; in other words, to innovate.

Gains from innovation are not always exploited. This is because contract innovations are not protected by patents and have very slim protection under copyright law. Contract innovation is a public good. It becomes harder to protect an investment in contract innovation when that innovation's use becomes widespread. On the other hand, widespread use makes innovations safer as users begin to realize network benefits. Network benefits arise where greater usage creates judicial precedent and a better understanding of the innovation in courts.

Additionally, contract innovation differs from technological innovation in several important ways. Primarily, as previously stated, contract innovations are not protected by patents or copyrights. The system of hourly billing that law firms have adopted in the United States also discourages research and development. When the price of products is related to the hours spent producing them, research and development has a negative effect on profits. Because of this, research and development is limited to seeking particular clients as there is no way to charge more for the use of new technologies when billing on an hourly basis.

This is not always the case. One of the most famous examples of contract innovation over the last 30 years is the poison pill. The firm that designed the poison pill, Wachtell, Lipton, Rosen & Katz, saw a demand in the market for takeover defenses that was not being satisfied. The firm marketed and sold the poison pill to clients, but unlike most other white shoe law firms, it engaged in value billing rather than hourly billing. In this way it followed a more traditional innovation model; the firm saw a need in the market, invested in research and development, and then charged a price for the product based on its value to the client. This model, however, is very rare, pointing to underinvestment in contract innovation.

My proposal, open contract design, is analogous to open source software development. While lawyers seem less amenable to collaboration than engineers, who are viewed as excited by and motivated toward collaboration, a tradition of collaboration among lawyers does exist. The Bar is a close-knit community of lawyers characterized by conferences, continuing education where lawyers are brought up to speed by other lawyers on cutting edge topics such as contract design, and the sharing of documents at seminars. The committees that draft default rules in commercial law are groups of lawyers and legal academics that work together on a regular basis. Such activities are examples of lawyers collaborating and volunteering their time without a monetary incentive.

While a tradition of collaboration among lawyers may exist, they lack the technology to work together in terms of contract innovation. This technology does exist, however, in the form of a wiki - the kind of software that Wikipedia is based on. A wiki can bring many lawyers together to work on the individual terms of a contract in a modular fashion, much like how software is developed in an open source system. It also exploits the fact that contributions are "granular," meaning that anyone can contribute, even just a word or two, thus allowing many lawyers connected through the Internet to make small contributions that can be fed into a combined contract. Additionally, a wiki need not invite for the posting of entire contracts; its focus may be on individual terms within a contract and the aforementioned shocks that tend to drive innovation.

The proposed system, the Harvard Law School Contracts Wiki, will be available online soon at It was created in partnership with Doug Barnard, a former partner at Kirkland & Ellis, and now corporate counsel for a public company. The software, Drupal, differs from other wikis in that it incorporates elements of blogs and wikis. The system will be open to the public and participants can include information about themselves, including their background and picture, in individual profiles. The aim of having each member identifiable is to the system more attractive to those who want their contributions to act as a kind of advertisement for themselves and their firms. However, certain individuals would rather remain anonymous to protect their reputations in case they make mistakes. For this reason, the option to contribute anonymously has been added to the system.

Each blog entry is triggered by a system shock. The first part of each entry discusses a noteworthy case -the shock- and then elucidates the need for innovation. For example, one blog entry written by Mr. Barnard, discusses the problem of beneficial ownership in corporate governance and provides two alternative definitions of beneficial ownership, one from the Louisiana-Pacific plan and the other from the Micrel rights plan. This blog and the suggested contract definitions can be edited by any future participant in the same way that entries are edited in Wikipedia with those users being credited for their interjections.

One option to editing a contract term is the addition of a child page, which can be used to offer an alternative provision to that of the original blogger. This page can be closed to edits or left open depending on the discretion of the author of the child page. When multiple opinions are offered on a given issue, polls can be set up to gauge the community's feelings on that particular issue. Additionally, participants can add comments to the poll explaining why they voted a certain way. If a participant does not vote at all, he can explain why he refrained from choosing a side.

To conclude, the site includes seven key features that are valuable in contract innovation. First, the site exploits the modularity of contracts by allowing provisions to be worked on individually and then inserted by participants into a range of different contracts. Second, contributions can be made at a granular level, inviting contributions of all sizes. Third, the agenda for innovation is decentralized; participants may contribute to what they feel are the most important issues rather than having clients determine the direction of research and development. Fourth, a large number of legal professionals and even the general public are welcome to participate. Fifth, contributions help to realize network benefits. As different users contribute to an entry, the proposal is vetted and uncertainty regarding the proposal's effectiveness is reduced. Sixth, the innovations produced through this site will be very dynamic due to the fact that contributions and entries will be direct responses to shocks in the market. Finally, the support of Harvard Law School widens the scope, funding, prestige, and neutrality of the wiki, thus contributing to the overall effectiveness of the system.

Three questions arise after considering this new venture. First, is it true that there is, in fact, underinvestment in contract innovation? In contract negotiations, each consenting party has an incentive to create drafts individually to suit their own purposes. Also, many international organizations invest heavily in drafting model contracts, like the ICC, for example. Second, how modular are contracts? For example, in venture capital investment contracts, entrepreneurs and venture capitalists negotiate on the terms of shared control and shared profits of a proposed venture. The contract drawn up from such negotiations is complementary to each party's position. It is hard to see the modularity in such a contract. Third, legal systems create a set of parameters within which negotiations take place and contracts express the results of these negotiations. How do you characterize the relationship between the drafting process of contracts through this wiki and the legal systems in which the actual drafting takes place?

It is true that each party in a contract has an advantage in being able to draft language in its own favor. However, as to the amount of investment in innovation, a client would invest in the development of a term in the contract if the value of putting it in the contract is greater than the cost of development. The cost to the individual client disregards the potential value that the term holds for multiple other parties. While organizations try to internalize this concept of benefit to multiple rather than single parties, the choices made by organizations on what innovations to pursue are heavily biased and made within a heterogeneous group.

As for modularity, even venture capital contracts have distinct pieces that can be mixed and matched for different purposes. In venture capital negotiation, the negotiations generally revolve around which individual terms to include in a contract. At conferences, anti-dilution provisions are not discussed in terms of a specific negotiation between certain parties, but rather how a lawyer might want to draft such provisions in various situations. This innovation ends up being quite modular as the provision can be used in a variety of contracts.

The wiki ends up being much more effective in a legal system that has more default rules than mandatory rules. A mandatory rules system does not allow for the same scope of contracting as a default rules system. Under a civil law system an enforceable contract must fit into one of the prescribed types of contracts under the law. New types of contracts are decided when weight of academic opinion, demand in the market, potential benefits to the economy, or other factors convince lawmakers to create a new category. Within such a system the wiki works as an effective tool in convincing lawmakers that a new type of category is in demand, why the demand exists, and what value can be created through its implementation. This would make the wiki an effective tool for law reform.

Questions and Answers

Q: What are some possible protections against harmful innovations in contract drafting?

Innovations developed through the wiki will still have to go through the same body of regulation as any other contract innovation. For example, unconscionability review by the courts or disclosure of certain financial products applies equally to products of the wiki as to all other contractual provisions.

Using the wiki for innovation offers more information on terms than a term developed at a law firm. A firm's intentions may be less clear than those of the contributors to the wiki. When contributing to the wiki, a lawyer has the protection of being able to fully explain his reasons for including a change in the comments section, and receives feedback from other lawyers that will strengthen the term. While this will not replace the need for regulation, it can produce information that will make regulations better.

Q: Could you please talk more about the technology you used to create the site and how it allows you to limit the amount of users on the site? Would the judicial branch be able to participate in the wiki or would that pose a conflict of interest?

Judges would most likely be hesitant to contribute to the wiki. Contributions from judges are welcomed, though, as the more minds and experts contributing will only increase the quality of the terms produced. Similarly, contributions from investment bankers, corporate officers, or those working in the field of civil law and other related fields would be helpful in strengthening the wiki.

As for limiting contributions, the site initially had background screening requirements where potential contributors were required to present their credentials to the administrators for a background check before being allowed to post or edit content. The wiki was later changed to a self-registration system allowing anyone to create an account where they can instantly gain full access to all features of the site. When logging in, only a person's desired username, email address, and optional biography are requested.

Q: Are the contractual provisions each totally modular when posted on the site?

Yes, just as information appears on Wikipedia.

Q: If a user would like to contribute to a project, can the user choose any contractual provision they like?

The way the site is structured, a shock must be chosen in order to begin a post and put up a contractual provision for review. However, if there is no sudden shock that a contribution is responding to, a participant may still contribute. In order to create a new post, the issue must be framed within the issue areas labeled as shocks, or the tabs that were previously referred to.

Q: I have three questions. First, modular systems are known to have great agility, but what kinds of quality controls have been put in place to ensure the integrity of the content? Second, do you think the wiki is applicable in a civil law system? Third, what academic research has influenced this project?

I did some reading on the subject for this project because I was interested in modularity in contracts. More and more work is being done on the open source software movement and my research focused primarily on those materials, primarily Yochai Benkler's book The Wealth of Networks.

Quality control runs a little bit differently with the wiki than open source software like Linux. Linux has a body of people integrating the modules together, whereas the modules on the wiki remain unattached for people to pick and choose from on the wiki. The participants are primarily responsible for quality control. When a term is posted, different participants can comment on it. From those comments any other participant can gauge opinion, and rather than any one person or body deciding which point of view might be best, each user can choose whichever opinion they are comfortable with, given the information provided by other users. Also, participants who adopt the terms posted on the wiki are encouraged to provide feedback on how they are eventually used. The wiki's goal is to provide information so participants can decide for themselves what provisions they want to use.

Even Wikipedia does not have as robust a quality assurance system as this wiki does because only one entry per term is allowed on Wikipedia. If one entry is edited, someone who disagrees with that edit can only re-edit it and the two users will go back and forth without resolution. In the Harvard Law Wiki, multiple entries can cover similar terms from different perspectives, leaving the choice of which to use up to the individual user.

The possibility exists, however, for breaches of the quality assurance framework to have a negative effect on the wiki. For example, if a truly disruptive user who knows less than he thinks he does begins making low quality edits to multiple entries, contributors may begin closing off their entries to edits for fear of the previous user's bad edits. In such a case the administrator would have to take action against the poor quality contributor to ensure overall quality.

Civil law contracts are admittedly less modular and this has an effect on the usefulness of the wiki in a civil law system. The wiki relies, to a large extent, on the modularity of contracts in a common law system. To the extent that civil law has some modularity, users can make use of the wiki. To the extent that it does not, the wiki model is still useful, but not in the same way as in its current iteration. In such a case, entire contracts or franchise agreements should be posted for contributions from users. While this whole document approach was the initially intended use of the wiki, the modular approach allows for a much more organized editing process in a common law system.

*This summary was compiled by RIETI Editorial staff.