Description
This paper aims to explain the economic impact of the change in the degree of contract
enforcement in the USA since August 2008. This change, from solid enforcement (hard contracts),
to uncertain enforcement (fuzzy contracts), is a result of political expediency during an economic crisis.
The purpose of the paper is to point out that political decisions are not made in an economic vacuum,
and that there is an economic impact to the move away from hard contracts
Journal of Financial Economic Policy
The economic impact of a shift from hard to fuzzy contracts
Glenna Sumner Anita Williams
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To cite this document:
Glenna Sumner Anita Williams, (2010),"The economic impact of a shift from hard to fuzzy contracts",
J ournal of Financial Economic Policy, Vol. 2 Iss 1 pp. 80 - 87
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The economic impact of a shift
from hard to fuzzy contracts
Glenna Sumner and Anita Williams
School of Business, Henderson State University, Arkadelphia, Arkansas, USA
Abstract
Purpose – This paper aims to explain the economic impact of the change in the degree of contract
enforcement in the USA since August 2008. This change, from solid enforcement (hard contracts),
to uncertain enforcement (fuzzy contracts), is a result of political expediency during an economic crisis.
The purpose of the paper is to point out that political decisions are not made in an economic vacuum,
and that there is an economic impact to the move away from hard contracts.
Design/methodology/approach – The paper uses a time value of money, net present value
approach with speci?c emphasis on the investor’s adjustment to the required rate of return in the face
of uncertain contract enforcement. Both closed and open economic systems are addressed.
Findings – The paper ?nds that in the shift to a fuzzy contract environment, investors will increase
the required rate of return on future investment contracts, thereby lowering the value of those assets.
Both individually, and in the aggregate, asset values will fall.
Research limitations/implications – The paper makes no attempt to evaluate reasons for or
against the institutional changes that produced the move to fuzzy contracts. The paper examines only
the resulting impact of the change on asset valuations.
Practical implications – Reducing the certainty of contract enforcement reduces asset valuations
and investment.
Originality/value – This paper ful?lls a need to be cognizant of the fact that actions of politicians
can have unintended economic consequences, using the speci?c example of the shift in contract
enforcement in the USA since August 2008.
Keywords Economic conditions, Politics, Government policy, Contract law, United States of America
Paper type Research paper
Introduction
Politicians do not make decisions in an economic vacuum. Whether they realize it or
not, the actions that they take have implications for economic activity within and
possibly beyond the borders of their own country. Take, for example, the recent shift in
attitude by the current US administration towards the sanctity of contracts.
Some contracts, such as those guaranteeing employee bonuses, guaranteeing that
an investor has purchased senior debt, or specifying mortgage debt contracts, have
recently been seen as ?exible and modi?able at the behest of government. These things
may seem like small changes made for the purpose of political expediency, but there
can be de?nite economic rami?cations to even the smallest changes in the solidity
of contracts. Our purpose is to show the impact of the reduction of predictability of
contract enforcement on asset valuation. To achieve this aim, we present a few
examples of instances where contracts previously seen as solid or hard, have become
what we will call “fuzzy.”
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
The authors would like to thank Paul Huo, Victor Claar, Dennis DiMarzio, and anonymous
reviewers for their valuable input on this paper.
JFEP
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Journal of Financial Economic Policy
Vol. 2 No. 1, 2010
pp. 80-87
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381011055352
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Some contracts are fuzzy by nature. One such contract that has been in existence for
decades is the contract of adhesion. While most contracts are entered into by “two alert
individuals, mindful of their self interest, hammering out agreement by a process of
hard bargaining,” these contracts more closely resemble “a ?y and ?ypaper” (Calamari
and Perillo, 1977, p. 6). An example of such a contract would be a credit card
agreement, whereby the card issuer raises the interest rate after the borrower has
borrowed too much to pay-off quickly.
Other than to mention the existence of adhesion contracts, this paper does not refer
to such when using the term fuzzy with respect to contracts. Rather, a fuzzy contract is
one which previously would have been considered sacrosanct; one which in previous
years would have been strictly enforced but which, due to a change in the institutional
environment, may not be enforced as the original contracting parties intended.
There have also been some excellent studies of the impact of the legal system on
economic growth. These studies give much insight into the origins of current contract
law. The two main categories of literature include the legal origins debate and
Had?eld’s causal characteristics approach. Speci?cally, the legal origins studies have
examined the historical roots of legal systems and the connections of these roots to
economic growth rates in society, while Had?eld’s (2008) causal characteristics
approach has instead used statistical methodologies to attempt to link institutional
legal characteristics and economic growth[1].
This paper, however, does not attempt to explore the historical roots or causal
connections of the legal system, other than to start at the same original premise, or the
“presumption that legal rules affect economic growth [. . .]” (Reitz, 2009). Instead, this
paper takes a micro view of one particular characteristic, enforcement of contracts.
We examine here one particular economic cause and effect, namely, if one
characteristic of the legal system changes, what will be its effect on the economic
system? Or more speci?cally, we seek to answer the question of what happens when
contracts become less enforceable (or more fuzzy) and how this will impact the
valuation of assets that derive value from the terms of those contracts.
One case of what we call a “fuzzy” contract, which at ?rst glance may have
appeared to be an isolated incident, ended its trip through the courts with an appeal to
the Supreme Court of the USA. When the appeal was denied, this “isolated incident”
was then sealed in history as a bankruptcy precedent.
This 2009 case involved senior debt of Chrysler that was not given precedence in the
Chrysler bankruptcy proceedings. Precedence was instead given to the auto workers
union. This was a dramatic change from past-bankruptcy practices and is an example
of the type of change in the legal environment that has changed previously hard
contracts to fuzzy ones.
Perhaps, the government’s motivation was based on stakeholder theory.
The stakeholder model as discussed by Letza et al. (2004) is another body of work that
may address these issues, since it offers a motivation for the recent change in the degree
of contract enforcement. The stakeholder model, which states that interested groups,
such as labor unions, should have more power in the running of a corporation than in the
traditional shareholder wealth maximization model[2], may provide insight into reasons
whythe auto workers unionreceivedsucha large proportionof assets inthe recent general
motors (GM) and Chrysler bankruptcies. But regardless of motivation, this decision by
government to negate senior debt-holder claims does have an economic impact.
Shift from hard
to fuzzy
contracts
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This paper only examines this resulting economic impact of the change from hard to
fuzzy contracts; we do not examine reasons for or against the political changes that
have resulted in the new rules for contract enforcement.
In other words, this is an exercise in positive, not normative, and economic science.
Our main goal is to explain what happens to the value of the individual contract and, in
the aggregate, to the surrounding economy when hard contracts become fuzzy.
The aforementioned change in senior debt contracts, from a historically ?rm
contract to one in which bankruptcy precedence was unexpectedly voided, is the type
of legal dilemma that this paper addresses. The contracting parties or more speci?cally
the claimants had expectations of strict enforcement, but due to institutional climate
change, enforcement became uncertain. The contract became fuzzy with respect to the
prospect of enforcement. In the next section, we examine speci?c cases that exhibit
the recent move from hard to fuzzy contracts.
Recent history
Once upon a time you could count on a contract in the USA unless an organization
went bankrupt; even then, if you were a secured creditor or a senior lender, you could
count on being ?rst in line (McCullagh, 2009). That was before the 2009 Chrysler
bankruptcy, whereby the executive branch changed the rules and in effect, took over
what used to be the sole purview of the judicial branch, speci?cally the bankruptcy
court (Walsh, 2009). The GMs bankruptcy likewise was organized by the executive
branch, despite the fact that the bankruptcy went to court.
In the Chrysler case, the rights of secured bond holders were subordinated to
unsecured debt owners (Rutenberg and Vlasic, 2009; McCullagh, 2009). According to
Rutenberg and Vlasic (2009), “Most of the major debt-holders, led by JPMorgan Chase,
agreed to write down the debt owed to them by more than two-thirds.” The hold-out
group, led by Oppenheimer, at ?rst refused to settle for the $29 on the dollar they
were offered but decided to disband (De La Merced, 2009). However, a month later,
three senior debt-holders petitioned the Supreme Court for a stay. They received
temporary approval, but the petition subsequently was denied (Indiana State Police
Pension Trust et al. v. Chrysler LLC et al., 2009; Center for Auto Safety et al. v. Chrysler
LLC et al., 2009; Patricia Pascale v. Chrysler LLC et al., 2009).
In the new GM, the US Government has about 61 percent interest, the United Auto
Workers Union 17.5 percent, the Canadian Government 11.7 percent, and the rest is
held by bond holders of the old GM. Once again, being senior debt-holders failed to
result in anticipated security (National Public Radio, 2009).
In addition to the issues faced by the previously mentioned bondholders, employees
with contracted bonuses also now face uncertainty. Although there was plenty of
hysteria about Merrill Lynch employees getting big bonuses in the face of the ?rm’s
disappointing results, there was very little media attention to the fact that these
bonuses were contracted employment agreements that were either not honored or
some employees were politically pressured to return their payments when received
(Walsh, 2009).
Executive pay rules applyto ?rms that take part insome formof Troubled Asset Relief
Program (TARP). The exact rules and to whom they apply depend on what version of
TARP appertains to a ?rm. These rules were established under the Emergency Economic
Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009
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(Cornell et al., 2009). Some of these rules appear to have been enforced retroactively or to
have required the rewriting of contracts.
Another type of contract that is now seen as rewritable is the mortgage. Since
August 2008, US mortgage holders have been encouraged to rewrite the terms of
mortgage contracts that homebuyers cannot afford (Barber, 2007; Consumer Reports,
2009).
All of these changes to the enforcement of contracts have happened within a very
short time period and have been a major change to the spirit of contract law that has
been in place since the very beginning of the formation of law in the USA. As an
example, take the words of the fourth President of the USA, Madison (1788), who once
stated that “[. . .] ex-post-facto laws and laws impairing the obligation of contracts are
contrary to the ?rst principles of the social compact, and to every principle of sound
legislation.”
While his words may ring true to many who make the study of markets and
contracts our profession, we restate that it is not the object of this paper to build a legal
case for or against hard or fuzzy contract enforcement. The reasons for the change,
whether real or fabricated, politically expedient or singularly trivial, are not relevant to
this discussion. Instead, we seek to show the economic implications of a change that
has already occurred.
What are these implications? As stated previously, government actions do not occur
in an economic vacuum. In a rational world, at the very least investors and lenders will
require a greater return in exchange for the additional risk they run that future
contracts will not be honored, particularly if they have no voice to challenge a decision.
What follows is an analysis of the impact of such fuzziness of contracts on time
honored asset valuation methodologies. In the next section, we examine how such
increased uncertainty impacts the mathematics of asset contract valuation.
The analysis
Let us de?ne the two legal environments as follows:
(1) Hard contracts. A legal environment such as existed in the USA prior to 2009.
(2) Fuzzy contracts. A legal environment in which a contract may or may not be
honored to the fullest extent depending upon future actions of government.
Assuming perpetuities
Let us begin our analysis with the assumption (for now) that all contracts are perpetuities.
The value of one contract in a hard contract environment would have been valued as:
P ¼
D
k
where:
P ¼ the contract value today.
D ¼ the payment expected per period in the future.
k ¼ the required rate of return, and 0 , k.
Now assume that today we are in a fuzzy contract environment, and in situ we do not
know for sure if the contract will be enforced. We will change our method of valuation
Shift from hard
to fuzzy
contracts
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by adding a fuzz factor ( f ) to the required rate of return. This fuzz factor is a risk
adjustment that will be larger, the greater the degree of doubt as to whether the
contract will ever be honored. Hence, we have:
P
f
¼
D
k þ f
where P
f
is the contract value today with uncertain or fuzzy contracts, f is a risk-related
compensation, and 0 , f , 1. Since D/(k þ f ) , D/k when f . 0, we have P
f
, P,
i.e. the value of the fuzzy contract is lower than the value of the hard contract.
Now to broaden this analysis to the entire economy, we simply ?nd the sum of all
contracts under either legal environment and we ?nd:
X
q
j¼1
ðP
f
Þ
j
,
X
q
j¼1
P
j
where q is the total quantity of contracts in the entire economy. The sumvalue today of all
contracts in a fuzzy contract environment is lower than in a hard contract environment.
Dropping the assumption of perpetuities
We can drop the assumption of perpetuities and still get the same result. Assume now
that contracts run for de?nite lengths of time. The present value of an individual
contract assuming hard contracts can be found as follows:
P ¼
X
n
i¼1
D
i
ð1 þ kÞ
i
where:
D
i
¼ the payment received in time period i.
k ¼ required rate of return on an investment of this level of risk.
n ¼ the total number of time periods of the contract.
P ¼ the value today of the contract.
Finding the value of a contract (P
f
) when contracts are fuzzy would be a similar
process, with the exception of the fuzz factor, which is once again added to the required
rate of return in the analysis, giving:
P
f
¼
X
n
i¼1
D
i
ð1 þ ðk þ f ÞÞ
i
and since (k þ f ) is greater than (k) when f . 0, the individual contract P
f
is worth less
than the individual contract P.
Extending this analysis to the entire economy, we take the summation of all
contracts in the economy. In the vernacular:
X
q
j¼1
X
n
i¼1
D
ij
ð1 þ ðk þ f ÞÞ
i
,
X
q
j¼1
X
n
i¼1
D
ij
ð1 þ kÞ
i
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or more simply:
X
q
j¼1
ðP
f
Þ
j
,
X
q
j¼1
P
j
where q is the total quantity of contracts in the entire economy.
As can be seen above, the sum value today of all contracts in a fuzzy contract
environment is lower than in a hard contract environment. In a capital budgeting
situation such as net present value (NPV) analysis, the fuzzy contract (as opposed to
the hard contract) is more likely to be rejected since it has the lower present value.
This means that, overall, fewer investment contracts will be accepted in the fuzzy
contract economy, which has a recessionary impact.
Open versus closed economy
The previous analysis is not limited to a closed economy. Investors worldwide may choose
from a menu of countries for investment purposes, each with a different level of contract
safety. Some countries have stronglyenforcedcontracts, andother countries have contracts
seen as rewritable by their governments. These international investors will engage in the
same analysis as that described above and will ?nd that countries with hard contracts
have investments that are worth more overall than countries with fuzzy contracts.
A rational investor has a menu of countries in which to invest, and will therefore
choose to invest in the countries with hard contracts more often than in countries with
fuzzy contracts. This leads to less investment from international investors for the fuzzy
contract country.
It would be interesting as a topic for future research to correlate countries’ degree of
contract certainty with overall investment within those countries.
Conclusion
As follows from the above analysis, with either open or closed economic systems,
investors who follow a rational NPV[3] analysis of asset valuation contracts will tend
to invest less in a system with the increased risk engendered by fuzzy contracts. This is
because, even without reducing the certainty of contracts, investors ?ght against
uncertainty. Economic valuation models such as the NPV have been developed to
attempt to place risk and time-weighted valuation on future cash ?ows (discounting)
using a required rate of return that has been adjusted for perceived risk. These
discounted future cash ?ows are then compared with the costs of initial investment to
determine whether the investment is viable.
Economic events lead to much uncertainty in asset valuation. Increasing
uncertainty in the enforcement of contracts does not improve upon the situation.
Higher risk leads to lower asset valuations, which when compared with the cost of the
initial investment, leads directly to less investment undertaken. Less investment leads
directly to less gross domestic product (GDP), since GDP is calculated as a sum of
spending which includes business investment[4].
Conversely, hard contracts reduce uncertainty, thereby lowering risk, and raising
asset valuations, directly increasing investment and therefore GDP.
Notes
1. An excellent review of this literature can be found in Reitz (2009). Additional sources of note
would be La Porta et al. (1998) and Had?eld (2008).
Shift from hard
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2. The shareholder wealth maximization model is widely known and will not be presented
in its entirety here. Greater detail is available in any of a number of business ?nance/
investment texts.
3. The NPV model is widely known and will not be presented in its entirety here. Greater detail
on NPV valuation is available in any of a number of business ?nance/investment texts.
4. The US Department of Commerce calculates GDP as the sum of consumer spending,
business investment, government spending, and net exports.
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)
Rutenberg, J. and Vlasic, B. (2009), “Chrysler ?les to seek bankruptcy protection”,
NYTimes.com, April 30, available at: www.nytimes.com/2009/05/01/business/01auto.
html (accessed July 24, 2009).
Walsh, M.W. (2009), “Contracts now seen as being rewritable”, The New York Times, March 30,
available at: www.nytimes.com/2009/03/31/business/economy/31contracts.html (accessed
July 21, 2009).
Corresponding author
Glenna Sumner can be contacted at: [email protected]
Shift from hard
to fuzzy
contracts
87
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doc_597239001.pdf
This paper aims to explain the economic impact of the change in the degree of contract
enforcement in the USA since August 2008. This change, from solid enforcement (hard contracts),
to uncertain enforcement (fuzzy contracts), is a result of political expediency during an economic crisis.
The purpose of the paper is to point out that political decisions are not made in an economic vacuum,
and that there is an economic impact to the move away from hard contracts
Journal of Financial Economic Policy
The economic impact of a shift from hard to fuzzy contracts
Glenna Sumner Anita Williams
Article information:
To cite this document:
Glenna Sumner Anita Williams, (2010),"The economic impact of a shift from hard to fuzzy contracts",
J ournal of Financial Economic Policy, Vol. 2 Iss 1 pp. 80 - 87
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The economic impact of a shift
from hard to fuzzy contracts
Glenna Sumner and Anita Williams
School of Business, Henderson State University, Arkadelphia, Arkansas, USA
Abstract
Purpose – This paper aims to explain the economic impact of the change in the degree of contract
enforcement in the USA since August 2008. This change, from solid enforcement (hard contracts),
to uncertain enforcement (fuzzy contracts), is a result of political expediency during an economic crisis.
The purpose of the paper is to point out that political decisions are not made in an economic vacuum,
and that there is an economic impact to the move away from hard contracts.
Design/methodology/approach – The paper uses a time value of money, net present value
approach with speci?c emphasis on the investor’s adjustment to the required rate of return in the face
of uncertain contract enforcement. Both closed and open economic systems are addressed.
Findings – The paper ?nds that in the shift to a fuzzy contract environment, investors will increase
the required rate of return on future investment contracts, thereby lowering the value of those assets.
Both individually, and in the aggregate, asset values will fall.
Research limitations/implications – The paper makes no attempt to evaluate reasons for or
against the institutional changes that produced the move to fuzzy contracts. The paper examines only
the resulting impact of the change on asset valuations.
Practical implications – Reducing the certainty of contract enforcement reduces asset valuations
and investment.
Originality/value – This paper ful?lls a need to be cognizant of the fact that actions of politicians
can have unintended economic consequences, using the speci?c example of the shift in contract
enforcement in the USA since August 2008.
Keywords Economic conditions, Politics, Government policy, Contract law, United States of America
Paper type Research paper
Introduction
Politicians do not make decisions in an economic vacuum. Whether they realize it or
not, the actions that they take have implications for economic activity within and
possibly beyond the borders of their own country. Take, for example, the recent shift in
attitude by the current US administration towards the sanctity of contracts.
Some contracts, such as those guaranteeing employee bonuses, guaranteeing that
an investor has purchased senior debt, or specifying mortgage debt contracts, have
recently been seen as ?exible and modi?able at the behest of government. These things
may seem like small changes made for the purpose of political expediency, but there
can be de?nite economic rami?cations to even the smallest changes in the solidity
of contracts. Our purpose is to show the impact of the reduction of predictability of
contract enforcement on asset valuation. To achieve this aim, we present a few
examples of instances where contracts previously seen as solid or hard, have become
what we will call “fuzzy.”
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
The authors would like to thank Paul Huo, Victor Claar, Dennis DiMarzio, and anonymous
reviewers for their valuable input on this paper.
JFEP
2,1
80
Journal of Financial Economic Policy
Vol. 2 No. 1, 2010
pp. 80-87
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381011055352
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Some contracts are fuzzy by nature. One such contract that has been in existence for
decades is the contract of adhesion. While most contracts are entered into by “two alert
individuals, mindful of their self interest, hammering out agreement by a process of
hard bargaining,” these contracts more closely resemble “a ?y and ?ypaper” (Calamari
and Perillo, 1977, p. 6). An example of such a contract would be a credit card
agreement, whereby the card issuer raises the interest rate after the borrower has
borrowed too much to pay-off quickly.
Other than to mention the existence of adhesion contracts, this paper does not refer
to such when using the term fuzzy with respect to contracts. Rather, a fuzzy contract is
one which previously would have been considered sacrosanct; one which in previous
years would have been strictly enforced but which, due to a change in the institutional
environment, may not be enforced as the original contracting parties intended.
There have also been some excellent studies of the impact of the legal system on
economic growth. These studies give much insight into the origins of current contract
law. The two main categories of literature include the legal origins debate and
Had?eld’s causal characteristics approach. Speci?cally, the legal origins studies have
examined the historical roots of legal systems and the connections of these roots to
economic growth rates in society, while Had?eld’s (2008) causal characteristics
approach has instead used statistical methodologies to attempt to link institutional
legal characteristics and economic growth[1].
This paper, however, does not attempt to explore the historical roots or causal
connections of the legal system, other than to start at the same original premise, or the
“presumption that legal rules affect economic growth [. . .]” (Reitz, 2009). Instead, this
paper takes a micro view of one particular characteristic, enforcement of contracts.
We examine here one particular economic cause and effect, namely, if one
characteristic of the legal system changes, what will be its effect on the economic
system? Or more speci?cally, we seek to answer the question of what happens when
contracts become less enforceable (or more fuzzy) and how this will impact the
valuation of assets that derive value from the terms of those contracts.
One case of what we call a “fuzzy” contract, which at ?rst glance may have
appeared to be an isolated incident, ended its trip through the courts with an appeal to
the Supreme Court of the USA. When the appeal was denied, this “isolated incident”
was then sealed in history as a bankruptcy precedent.
This 2009 case involved senior debt of Chrysler that was not given precedence in the
Chrysler bankruptcy proceedings. Precedence was instead given to the auto workers
union. This was a dramatic change from past-bankruptcy practices and is an example
of the type of change in the legal environment that has changed previously hard
contracts to fuzzy ones.
Perhaps, the government’s motivation was based on stakeholder theory.
The stakeholder model as discussed by Letza et al. (2004) is another body of work that
may address these issues, since it offers a motivation for the recent change in the degree
of contract enforcement. The stakeholder model, which states that interested groups,
such as labor unions, should have more power in the running of a corporation than in the
traditional shareholder wealth maximization model[2], may provide insight into reasons
whythe auto workers unionreceivedsucha large proportionof assets inthe recent general
motors (GM) and Chrysler bankruptcies. But regardless of motivation, this decision by
government to negate senior debt-holder claims does have an economic impact.
Shift from hard
to fuzzy
contracts
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This paper only examines this resulting economic impact of the change from hard to
fuzzy contracts; we do not examine reasons for or against the political changes that
have resulted in the new rules for contract enforcement.
In other words, this is an exercise in positive, not normative, and economic science.
Our main goal is to explain what happens to the value of the individual contract and, in
the aggregate, to the surrounding economy when hard contracts become fuzzy.
The aforementioned change in senior debt contracts, from a historically ?rm
contract to one in which bankruptcy precedence was unexpectedly voided, is the type
of legal dilemma that this paper addresses. The contracting parties or more speci?cally
the claimants had expectations of strict enforcement, but due to institutional climate
change, enforcement became uncertain. The contract became fuzzy with respect to the
prospect of enforcement. In the next section, we examine speci?c cases that exhibit
the recent move from hard to fuzzy contracts.
Recent history
Once upon a time you could count on a contract in the USA unless an organization
went bankrupt; even then, if you were a secured creditor or a senior lender, you could
count on being ?rst in line (McCullagh, 2009). That was before the 2009 Chrysler
bankruptcy, whereby the executive branch changed the rules and in effect, took over
what used to be the sole purview of the judicial branch, speci?cally the bankruptcy
court (Walsh, 2009). The GMs bankruptcy likewise was organized by the executive
branch, despite the fact that the bankruptcy went to court.
In the Chrysler case, the rights of secured bond holders were subordinated to
unsecured debt owners (Rutenberg and Vlasic, 2009; McCullagh, 2009). According to
Rutenberg and Vlasic (2009), “Most of the major debt-holders, led by JPMorgan Chase,
agreed to write down the debt owed to them by more than two-thirds.” The hold-out
group, led by Oppenheimer, at ?rst refused to settle for the $29 on the dollar they
were offered but decided to disband (De La Merced, 2009). However, a month later,
three senior debt-holders petitioned the Supreme Court for a stay. They received
temporary approval, but the petition subsequently was denied (Indiana State Police
Pension Trust et al. v. Chrysler LLC et al., 2009; Center for Auto Safety et al. v. Chrysler
LLC et al., 2009; Patricia Pascale v. Chrysler LLC et al., 2009).
In the new GM, the US Government has about 61 percent interest, the United Auto
Workers Union 17.5 percent, the Canadian Government 11.7 percent, and the rest is
held by bond holders of the old GM. Once again, being senior debt-holders failed to
result in anticipated security (National Public Radio, 2009).
In addition to the issues faced by the previously mentioned bondholders, employees
with contracted bonuses also now face uncertainty. Although there was plenty of
hysteria about Merrill Lynch employees getting big bonuses in the face of the ?rm’s
disappointing results, there was very little media attention to the fact that these
bonuses were contracted employment agreements that were either not honored or
some employees were politically pressured to return their payments when received
(Walsh, 2009).
Executive pay rules applyto ?rms that take part insome formof Troubled Asset Relief
Program (TARP). The exact rules and to whom they apply depend on what version of
TARP appertains to a ?rm. These rules were established under the Emergency Economic
Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009
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(Cornell et al., 2009). Some of these rules appear to have been enforced retroactively or to
have required the rewriting of contracts.
Another type of contract that is now seen as rewritable is the mortgage. Since
August 2008, US mortgage holders have been encouraged to rewrite the terms of
mortgage contracts that homebuyers cannot afford (Barber, 2007; Consumer Reports,
2009).
All of these changes to the enforcement of contracts have happened within a very
short time period and have been a major change to the spirit of contract law that has
been in place since the very beginning of the formation of law in the USA. As an
example, take the words of the fourth President of the USA, Madison (1788), who once
stated that “[. . .] ex-post-facto laws and laws impairing the obligation of contracts are
contrary to the ?rst principles of the social compact, and to every principle of sound
legislation.”
While his words may ring true to many who make the study of markets and
contracts our profession, we restate that it is not the object of this paper to build a legal
case for or against hard or fuzzy contract enforcement. The reasons for the change,
whether real or fabricated, politically expedient or singularly trivial, are not relevant to
this discussion. Instead, we seek to show the economic implications of a change that
has already occurred.
What are these implications? As stated previously, government actions do not occur
in an economic vacuum. In a rational world, at the very least investors and lenders will
require a greater return in exchange for the additional risk they run that future
contracts will not be honored, particularly if they have no voice to challenge a decision.
What follows is an analysis of the impact of such fuzziness of contracts on time
honored asset valuation methodologies. In the next section, we examine how such
increased uncertainty impacts the mathematics of asset contract valuation.
The analysis
Let us de?ne the two legal environments as follows:
(1) Hard contracts. A legal environment such as existed in the USA prior to 2009.
(2) Fuzzy contracts. A legal environment in which a contract may or may not be
honored to the fullest extent depending upon future actions of government.
Assuming perpetuities
Let us begin our analysis with the assumption (for now) that all contracts are perpetuities.
The value of one contract in a hard contract environment would have been valued as:
P ¼
D
k
where:
P ¼ the contract value today.
D ¼ the payment expected per period in the future.
k ¼ the required rate of return, and 0 , k.
Now assume that today we are in a fuzzy contract environment, and in situ we do not
know for sure if the contract will be enforced. We will change our method of valuation
Shift from hard
to fuzzy
contracts
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by adding a fuzz factor ( f ) to the required rate of return. This fuzz factor is a risk
adjustment that will be larger, the greater the degree of doubt as to whether the
contract will ever be honored. Hence, we have:
P
f
¼
D
k þ f
where P
f
is the contract value today with uncertain or fuzzy contracts, f is a risk-related
compensation, and 0 , f , 1. Since D/(k þ f ) , D/k when f . 0, we have P
f
, P,
i.e. the value of the fuzzy contract is lower than the value of the hard contract.
Now to broaden this analysis to the entire economy, we simply ?nd the sum of all
contracts under either legal environment and we ?nd:
X
q
j¼1
ðP
f
Þ
j
,
X
q
j¼1
P
j
where q is the total quantity of contracts in the entire economy. The sumvalue today of all
contracts in a fuzzy contract environment is lower than in a hard contract environment.
Dropping the assumption of perpetuities
We can drop the assumption of perpetuities and still get the same result. Assume now
that contracts run for de?nite lengths of time. The present value of an individual
contract assuming hard contracts can be found as follows:
P ¼
X
n
i¼1
D
i
ð1 þ kÞ
i
where:
D
i
¼ the payment received in time period i.
k ¼ required rate of return on an investment of this level of risk.
n ¼ the total number of time periods of the contract.
P ¼ the value today of the contract.
Finding the value of a contract (P
f
) when contracts are fuzzy would be a similar
process, with the exception of the fuzz factor, which is once again added to the required
rate of return in the analysis, giving:
P
f
¼
X
n
i¼1
D
i
ð1 þ ðk þ f ÞÞ
i
and since (k þ f ) is greater than (k) when f . 0, the individual contract P
f
is worth less
than the individual contract P.
Extending this analysis to the entire economy, we take the summation of all
contracts in the economy. In the vernacular:
X
q
j¼1
X
n
i¼1
D
ij
ð1 þ ðk þ f ÞÞ
i
,
X
q
j¼1
X
n
i¼1
D
ij
ð1 þ kÞ
i
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or more simply:
X
q
j¼1
ðP
f
Þ
j
,
X
q
j¼1
P
j
where q is the total quantity of contracts in the entire economy.
As can be seen above, the sum value today of all contracts in a fuzzy contract
environment is lower than in a hard contract environment. In a capital budgeting
situation such as net present value (NPV) analysis, the fuzzy contract (as opposed to
the hard contract) is more likely to be rejected since it has the lower present value.
This means that, overall, fewer investment contracts will be accepted in the fuzzy
contract economy, which has a recessionary impact.
Open versus closed economy
The previous analysis is not limited to a closed economy. Investors worldwide may choose
from a menu of countries for investment purposes, each with a different level of contract
safety. Some countries have stronglyenforcedcontracts, andother countries have contracts
seen as rewritable by their governments. These international investors will engage in the
same analysis as that described above and will ?nd that countries with hard contracts
have investments that are worth more overall than countries with fuzzy contracts.
A rational investor has a menu of countries in which to invest, and will therefore
choose to invest in the countries with hard contracts more often than in countries with
fuzzy contracts. This leads to less investment from international investors for the fuzzy
contract country.
It would be interesting as a topic for future research to correlate countries’ degree of
contract certainty with overall investment within those countries.
Conclusion
As follows from the above analysis, with either open or closed economic systems,
investors who follow a rational NPV[3] analysis of asset valuation contracts will tend
to invest less in a system with the increased risk engendered by fuzzy contracts. This is
because, even without reducing the certainty of contracts, investors ?ght against
uncertainty. Economic valuation models such as the NPV have been developed to
attempt to place risk and time-weighted valuation on future cash ?ows (discounting)
using a required rate of return that has been adjusted for perceived risk. These
discounted future cash ?ows are then compared with the costs of initial investment to
determine whether the investment is viable.
Economic events lead to much uncertainty in asset valuation. Increasing
uncertainty in the enforcement of contracts does not improve upon the situation.
Higher risk leads to lower asset valuations, which when compared with the cost of the
initial investment, leads directly to less investment undertaken. Less investment leads
directly to less gross domestic product (GDP), since GDP is calculated as a sum of
spending which includes business investment[4].
Conversely, hard contracts reduce uncertainty, thereby lowering risk, and raising
asset valuations, directly increasing investment and therefore GDP.
Notes
1. An excellent review of this literature can be found in Reitz (2009). Additional sources of note
would be La Porta et al. (1998) and Had?eld (2008).
Shift from hard
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2. The shareholder wealth maximization model is widely known and will not be presented
in its entirety here. Greater detail is available in any of a number of business ?nance/
investment texts.
3. The NPV model is widely known and will not be presented in its entirety here. Greater detail
on NPV valuation is available in any of a number of business ?nance/investment texts.
4. The US Department of Commerce calculates GDP as the sum of consumer spending,
business investment, government spending, and net exports.
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Corresponding author
Glenna Sumner can be contacted at: [email protected]
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