Conceptualizing Contractual Interpretation

Many litigated written contracts require interpretation, but few formal treatments of the interpretive process exist. This paper analyzes welfare-maximizing interpretive rules. It shows that (1) accurate interpretations maximize expected gains by rewarding parties only for compliant performances; (2) an optimal interpretive rule trades off these gains against the costs of writing contracts, investing in the deal, and trials; (3) an efficient interpretive process sometimes requires an adjudicator to decide on the basis of the writing and the tendered performance, without a trial; (4) courts maximize accuracy in interpretation rather than welfare, which yields too many trials, prevents some efficient contracting relationships from forming, and distorts contract writing; (5) party preferences regarding interpretation often are closer to first best than judicial preferences, so legal interpretive rules should be defaults; and (6) arbitration is more attractive to parties when the interpretive task requires inferring intent from a tendered performance rather than from a writing.