Relationship-Specific Investment, Asymmetric Information, and the Role of Knowledge-Based Obligations in Contracts

Relationship-specific investments that increase the contracting surplus can also endow the investing party with private information that affects the bargaining process. Investment by a manufacturer to learn about the idiosyncratic needs of its buyers is one example; another is research and development expenditure in a joint venture project by a partner. The presence of private information can lead to ex post bargaining failure (ex post inefficiency) which, in turn, can dampen the ex ante relationship-specific investment incentive (ex ante inefficiency). This paper examines how various contractual mechanisms can mitigate these problems. First, the paper demonstrates that the inefficiencies may be exacerbated when the parties enter into a binding trade agreement before the investment and rely on ex post modification to incorporate the information revealed by the investment. This is because the informed party is protected from bargaining failure at the modification stage by its ability to fall back on the terms of the initial agreement. This finding offers an explanation for why preliminary agreements in commercial transactions are often expressly non-binding, even when they contain all or most of the essential terms of the deal. Conventional scholarship, in contrast, holds that such agreements should be binding in order to protect subsequent specific investments from hold-up. Second, we examine a category of contract provisions, which we label as “knowledge-based” because they condition on the contracting parties’ knowledge. This category includes representations to the best of the party’s knowledge and the obligation to negotiate in good faith. Unlike warranties that are triggered by unsatisfactory outcomes, these knowledge-based provisions call on the courts to ascertain the party’s knowledge or behavior at the time of the contract or modification, an exercise that entails both expense and risk of error. Despite these costs, we show that, when combined with appropriately calibrated measures of liability, these provisions can significantly improve the efficiency of investment and contract terms. This result shows why, in certain circumstances, commercial parties expressly agree to assume the obligation to negotiate in good faith in an otherwise non-binding initial agreement. Third, the paper identifies conditions under which backing the knowledge-based obligations with expectation damages allows the parties to achieve both the ex ante and ex post efficiencies better than reliance damages.