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Let us start with the following joke:
Two business partners asked their lawyer to hold $20,000, making him promise to get both of their signatures before disbursing any of it. As soon as one partner left town, the other pressed the lawyer for $15,000, citing an emergency. The lawyer reluctantly gave it to him, and he disappeared. On his return, the other partner was irate, so the lawyer explained that he had donated the $15,000 out of his own pocket.
“Then give me the $20,000 you’re holding,” said the partner.
“All right,” said the lawyer. “Give me the two signatures.”
__________
These two business partners and their lawyer should have signed a contract. If the lawyer disbursed any of the partners’ money without having both of their signatures, he would face legal action for breach of contract. However, this contract would still not be immune to collusion: one of the two partners could split the money with the lawyer and disappear, and the other partner would never have the two signatures required by contract to have his money back. How would you design a better contract? By “better contract”, I mean:
- a contract that would NOT give any of the parties involved an incentive to break it.
- a contract that would be robust (and, ideally, immune) to collusion.
I make no claims that such a “perfect contract” even exists, but maybe one could devise a contract that would be better than the aforementioned one. Purely for recreational purposes, I propose a challenge: try to design the best contract you can think of!
If you have any ideas, please feel free to share them.
Tags: Contract Design, Contract Theory, Legal Loopholes, Puzzles
May 15, 2009 at 22:25 |
The two partners are paying the Lawyer to insure against their counterparty risk. The Lawyer should do similar and insure himself against theft, forgery or other shenanigans.
It’s not one, perfect, contract. It’s the web of contracts.
May 16, 2009 at 12:54 |
If one single contract does not provide enough insurance against all foreseen contingencies, I am all for devising a web of contracts that does the job.
However, let us keep in mind that the crux of the matter is how to devise a web of contracts that insures the parties involved against collusion.
May 16, 2009 at 09:38 |
Well, to start with there would be a clause that if one partner is absent / location unknown for a given period of time, the other partner will be awarded the money by default. This would protect against collusion between one partner and the lawyer. I can’t think of any loopholes in this… please let me know if any of you do.
May 16, 2009 at 14:36 |
I like your idea. The biggest flaw of the original contract is that the partners are not insured against the other partner disappearing. The contract you proposed would provide such insurance.
However, I wonder how one could prove that someone is absent. For instance, partner A could split the money with the lawyer and disappear; a few months later, when partner B tried to get his money back claiming that partner A had disappeared, the lawyer could reply: “What? I saw him last week!!”. Well, I suppose that partner B could then move legal action against the crooked lawyer and force him to prove that partner A was indeed not absent. Partner A would be subpoenaed and he would be screwed. Thus, your contract would probably work.
Loopholes that could be exploited: one partner could have the other partner killed (i.e., absent ad eternum), or have him incarcerated for a long period of time… but that would lead to an homicide / kidnapping investigation ;-)
One interesting possibility would be to sign a 1-year contract. After 12 months, the contract would expire and the lawyer would disburse $10,000 to each of the partners, and these would decide whether to sign a new 1-year contract or not. If the lawyer colluded with one the partners and that partner disappeared, he would still have to pay $10,000 to the other partner. That should dissuade the lawyer from colluding with any of the partners. This contract seems quite robust to collusion. What do you think?
May 16, 2009 at 16:11 |
Hmm… yeah, that would be good idea, except I don’t know why anyone would require such a contract in the first place. Is it me or is it that we are beginning to enter game theory and are trying to devise a zero-sum game kinda situation???
May 16, 2009 at 16:31 |
I don’t know why anyone would require such a contract either. It would make a lot more sense for the two partners to open a joint bank account and agree that two signatures would be required to withdraw any of the money. Banks have an incentive to honor these contracts, and collusion would most likely not be something to worry about.
What I like about this post’s example is that it’s possibly the simplest problem one can think of where collusion can happen. It’s a toy model.
May 27, 2009 at 16:57 |
The lawyer is the counterparty risk… and this sounds like a prisoner’s dilemma – is it not? Then it depends on whether the parties are going to see each other again (repeated game or one time shot) I think this is about game theory and contracts.
May 30, 2009 at 15:40 |
Yes, indeed this is about contract theory and game theory. I did not formulate the challenge explicitly under a game-theoretic framework because I did not want to make it sound too academic. I wanted to keep thing as down to earth as possible to see what ideas people would come up with.
July 7, 2010 at 19:33 |
The contract needs a clause saying that the contract must be executed within a given time period (say 60 days) or the escrowed funds (as the $20,000 was) is refunded. Notice the irony exists because the funds can’t be returned according to the agreement. (though the humor may be due to another reason).
To take this to a logical end, on death of a given party that particular portion is paid to the estate. This also helps address a contingency whereby one of the three parties seeks an injunction to prevent the return of funds. Addressing “What to do if …” helps ensure that a suit isn’t likely to get tied up in court as a result of this merely by virtue of not being addressed in the contract terms.
Just like good software, its all about planning.