Freedom of Contract and Contract Costs

by on November 3, 2008 · 28 comments

I made the point last week that freedom of contract includes the right not to be party to contracts without your consent, and that consent has to involve some sort of affirmative action. Shrink-wrap contracts that are presented only after a sale is complete don’t cut it in my view. If the contract wasn’t available for review at the point of sale, then I don’t care what might be in the box. You didn’t consent to the contract.

Now, some people might (and in the comments to previous posts, did) claim that this is just nitpicking, and that the really important thing is to promote economic efficiency by making contract formation easier. On this theory, contract negotiations are a transaction cost, and it’s economically beneficial to lower transaction costs as much as possible. So even if you haven’t technically agreed to the shrink-wrap EULA before you leave Best Buy, some people might argue that you “should have known” there would be a EULA in the box, and therefore it’s economically efficient to bind you to the contract unless you return the product to the store.

The problem with this argument is that it focuses myopically on the costs of contract negotiation to the exclusion of other costs that in many cases are much more important. It should be remembered that every contract signed is a prelude to possible state coercion if the contract is broken. Like all other kinds of coercion, the possibility of contract-related litigation creates uncertainty and other deadweight costs. In addition, the act of offering contracts imposes a deadweight cost. Every time I’m presented with a contract, I have to at least skim through it to make sure that the terms are acceptable. A society in which contract formation is extremely cheap for one party will be a society in which other people have to spend a lot of time scrutinizing the contracts they offer. Finally, contracts impose costs on the court system. A legal system that makes contracts to cheap to create will lead to too much taxpayer money being wasted on contract litigation.

All of which is to say that economic efficiency is not promoted by making contract formation as cheap as possible. Rather, the goal should be to align incentives so that a party only offers a contract if its benefits to all parties outweigh its expected costs. One thing that we should particularly try to avoid is a situation in which offering contracts is almost costless to one party, but reviewing them is expensive for the other party. Because then the offering party will offer inefficiently many contracts favorable to itself, and its counterparties will accept inefficiently many contracts because the costs of scrutinizing them individually is too high.

In contrast, if things are structured so that each party bears roughly half the costs of contract negotiation, then each party is only going to propose a formal, written contract if he believes that the benefits of doing so will outweigh the costs to both parties. This is one of the good things about paper contract negotiations between flesh-and-blood people: If you give me a long contract to sign, you’re going to have to stand there and wait while I read the contract and decide if I want to sign it. Since standing around is a waste of your time, you’re only going to do that if you believe the transaction can’t happen without it. And you’re going to try to make the contract as short as possible so you don’t have to stand around too long.

In the vast majority of business transactions, the default UCC terms work just fine. Grocery stores don’t try to attach contracts to the items they sell because it would slow down the checkout line too much if customers had to stand around reading their Banana Licensing Agreements before they were allowed to take their groceries home.

The reason shrinkwrap licenses on software are more popular than supermarket checkout contracts is not because software sales are some kind of exotic financial transaction that require special contractual terms. The UCC defaults can and do work just fine for software. Rather, the reason software firms make extensive use of EULAs is because they’ve found a clever gimmick that allows them to use copyright law as a way to bypass the ordinary rules of contract law and foist almost all the costs of contract negotiation onto the customer.

If a grocery store checkout clerk slipped a Banana Licensing Agreement into your grocery bag, no court of law would regard that as an enforceable contract. But software vendors have been pushing the legal fiction that software is licensed rather than sold. And if software is licensed rather than sold, then using software without accepting the license agreement is copyright infringement, which operates under an entirely different set of rules than ordinary contract law.

This claim is pretty clearly contrary to copyright’s First Sale Doctrine, and some courts have explicitly rejected it in some cases, but other courts have upheld it, and software vendors find the ability to skirt the ordinary rules of contract law so convenient that they keep trying.

But as a policy matter, there isn’t any good reason to let them get away with it. It would be bad policy to allow grocery stores to attach Banana License Agreements to their customers’ banana purchases by putting a BLA in each grocery bag, and it’s equally bad policy to allow software vendors to bind their customers to contracts they’re not able to review until after a sale is made. If software vendors want the software they sell to come with particular contractual restrictions, they should have the clerk at Best Buy provide the customer with a copy of the license agreement and require her to sign it before she can leave the store. If software vendors aren’t willing to put their customers through that hassle (and I’d bet money that they’re not) then it’s obviously not that important to them for their products to come with contractual restrictions attached, in which case the right outcome is for the software to be sold without special contractual restrictions, the same way that movies, music, books, and other creative works do.

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