The Three and a Half Minute Transaction: Boilerplate and the Limits of Contract Design

The Three and a Half Minute Transaction: Boilerplate and the Limits of Contract Design

by Mitu Gulati, Robert E. Scott

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Boilerplate language in contracts tends to stick around long after its origins and purpose have been forgotten. Usually there are no serious repercussions, but sometimes it can cause unexpected problems. Such was the case with the obscure pari passu clause in cross-border sovereign debt contracts, until a novel judicial interpretation rattled international

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Boilerplate language in contracts tends to stick around long after its origins and purpose have been forgotten. Usually there are no serious repercussions, but sometimes it can cause unexpected problems. Such was the case with the obscure pari passu clause in cross-border sovereign debt contracts, until a novel judicial interpretation rattled international finance by forcing a defaulting sovereign—for one of the first times in the market’s centuries-long history—to repay its foreign creditors. Though neither party wanted this outcome, the vast majority of contracts subsequently issued demonstrate virtually no attempt to clarify the imprecise language of the clause.

Using this case as a launching pad to explore the broader issue of the “stickiness” of contract boilerplate, Mitu Gulati and Robert E. Scott have sifted through more than one thousand sovereign debt contracts and interviewed hundreds of practitioners to show that the problem actually lies in the nature of the modern corporate law firm. The financial pressure on large firms to maintain a high volume of transactions contributes to an array of problems that deter innovation. With the near certainty of massive sovereign debt restructuring in Europe, The Three and a Half Minute Transaction speaks to critical issues facing the industry and has broader implications for contract design that will ensure it remains relevant to our understanding of legal practice long after the debt crisis has subsided.

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Editorial Reviews

J. Mark Ramseyer

“Mitu Gulati and Robert E. Scott have assembled extraordinarily tantalizing evidence that even the most sophisticated contracting parties—in this case, the top investment banks and law firms responsible for issuing the bonds at the center of the European debt crisis—use contractual provisions that neither side understands, and they continue to use these clauses even when they stand to be interpreted in a mutually disadvantageous way. Modern law firms have become so obsessed with profitability that they simply maximize the number of deals they conclude, whether the documents make sense to anyone or not. The book draws the reader in as the authors explore what could possibly be going on in the law firms and investment banks of Wall Street. Like a good detective story, it is an absolute delight to read.”
Robert C. Ellickson

"Drawing on over two hundred interviews, Mitu Gulati and Robert E. Scott provide an eye-opening account of the institutional pressures on attorneys who prepare contracts that undergird huge financial deals. A contract of this sort consists mostly of boilerplate terms, that is, clauses copied from prior deals. The authors insightfully explore why most lawyers engage in this sort of herd behavior, but also why they respect the few who stray from the herd. A landmark study of the folkways of high-powered transactional lawyers."
David A. Skeel

"With The Three and a Half Minute Transaction, leading legal scholars Mitu Gulati and Robert E. Scott offer the first work to fully untangle the complicated history of the pari passu clause, whose continued appearance in sovereign debt contracts constitutes a major puzzle in international finance. Gulati and Scott have interviewed the key players and assembled a unique database of sovereign bonds dating back to the nineteenth century in order to explain this anomaly. The standard explanations, they show, are simply not borne out by the evidence. Rather, the best answer lies in the large law firms that dominate sovereign finance. This is a very important book that provides a wonderfully textured account of the world of sovereign debt."

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University of Chicago Press
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Chicago Series in Law and Society
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The Three and a Half Minute Transaction

Boilerplate and the Limits of Contract Design


Copyright © 2013 The University of Chicago
All right reserved.

ISBN: 978-0-226-92438-0

Chapter One

A Story of Sticky Boilerplate Begins in Brussels

You have to understand the system. No one pays that much attention to the minute details like this. One cannot afford to, if one wants to stay competitive. The firm has a computer program. You know ... one that a junior associate can go to and plug the relevant parameters into—you know, type of issuance, type of issuer, which side we are representing, etc.,—and the computer generates a standard contract. The firm spent [a large amount] on putting together this system. Associates can now produce a contract for one of these deals in three and a half minutes. This is the future of contracting in these markets.

* * *

Had it been your fate to practice law sometime during the relatively uneventful period that elapsed between the end of the Peloponnesian Wars and the first O.J. trial, you would view contract drafting very differently. Every word of every contract you prepared would have called for physical labor on the part of both the author and the typist: hands clutching pens, fingers hitting keys, eyes proofreading text. Not anymore. You have joined the legal profession at a time when the sentence "I drafted the Agreement" is universally understood to mean "I sucked 99.7% of the Agreement off some electronic blob on a word processor."...

The munificence of these machines is therefore a mixed blessing. On the positive side, they help ensure uniformity throughout the Firm in the drafting of boilerplate provisions, they are the medium through which some carefully considered judgments about contract wording are communicated to succeeding generations of lawyers in the Firm, and they often allow us to meet a client's expectations about delivery schedules and cost. On the darker side, the ready availability of prefabricated contracts means that new lawyers have less of an opportunity to practice the craft of contract drafting. Far too much of the revealed text is preserved in each new incarnation of the document, mostly because an inexperienced drafter will not be sure why it is there or whether taking it out would help or hurt the document.

Long before the days of computers, lawyers were justifying their fondness for standardized contract terms—the paradigmatic "boilerplate" found in virtually all commercial contracts (even those that are carefully negotiated). Paul Cravath, of the Cravath firm, in a speech given in 1916, exhorted his listeners to place their implicit confidence in models and precedents.

The provisions of the modern reorganization agreement and the modern corporate mortgage are the result of the experience and prophetic vision of a great many able lawyers.... It would indeed be a courageous man who would say that any of the provisions which some of these lawyers have conceived to be wise should be rejected simply because he cannot for the moment think when or how it will become useful."

But we suspect that if Mr. Cravath had been asked how lawyers at his firm should respond to a court decision interpreting a contract provision in a manner different from the intent of its drafters, he would have said that it was unacceptable not to immediately clarify the offending provision. In sophisticated markets, theory tells us that the response from the Cravaths of the world to a court decision misinterpreting the meaning of a widely used standard contract provision should be rapid, if not immediate. Some cases, to be sure, promote legitimate debate about whether the newly minted judicial interpretation is erroneous. In such cases, new formulations may evolve more slowly as parties grapple with the language that best represents the shared understanding of the risks the clause allocates. But sometimes the meaning of a standard, widely used clause is universally accepted in the relevant community. Here an interpretation that differs from that common wisdom is sure to receive quick attention. Subsequently drafted contracts should amend or clarify the meaning of the clause to avoid the risk that the court's erroneous interpretation will apply in the future.

Reality is different, particularly when it comes to contracts with boilerplate clauses. Boilerplate clauses—standardized clauses that have been used by rote over long periods of time—often remain unchanged, even when a court decision has created uncertainty regarding the clauses' meaning. In short, boilerplate clauses are sticky: They seem resistant to amendment even when amendment seems desirable. Multiple theories for contract stickiness have been advanced. But the academic understanding of the stickiness phenomenon sits at the point of post hoc rationalizations—understandable in light of the difficulty of empirically testing for the factors that produce resistance to change. Testing for the factors that might induce a revision in boilerplate language is straightforward; one looks to theory for factors that might cause change and then examines the data to see which of the possible causal factors moved in line with the change. But with factors that impede revision, it is less clear how one might empirically test the theoretical conjectures; nothing changes, meaning there are no correlations to observe.

We attempt to shed light on the question of sticky boilerplate using what will undoubtedly strike some readers as a naive technique. We went into the field and asked the lawyers drafting these contracts why they had not altered the standard language in light of what they universally claimed was an aberrant interpretation of its meaning. These were sophisticated market actors, many of whom had clear views about why they behaved in certain ways. Our aim was not only to gain traction on the reasons why boilerplate was resistant to revision, but also to obtain insight into the world of elite law firm practice. The production (and maintenance) of boilerplate contracts is, in many respects, the lifeblood of transactional practice in today's law firms. To the extent we are able to understand the assembly-line process that produces these contracts, we can better appreciate both the strengths and the deficiencies of the business model employed by the modern big law firm.

To put our findings in context, we put the views of the respondents together with both the regnant theories accounting for sticky boilerplate and a quantitative analysis of the contracts themselves. Viewing the stories told by the respondents against the backdrop of theory and the available empirical evidence provides a test of a consistency hypothesis: If the stories are neither consistent with theory or the evidence, then what explains what we have been told? Alternatively, if the stories are consistent with the theory but not the evidence, what explains the myths that lawyers tell themselves? We hope this approach reveals a richer picture both of the stickiness phenomenon and the nature of modern law practice.

The form of narrative in this book follows the preceding structure in that explanations from the respondents are juxtaposed against the theories that purport to explain the same phenomenon. The quantitative data on sovereign bond contracts and the general legal structure governing these contracts provide the context for this juxtaposition of theory and the explanations of the market actors themselves. For example, a number of respondents report that they did not revise their contract clauses because they believed that courts would penalize them by adopting the heretical interpretation for all previously negotiated contracts that contained the same language. We then ask whether this explanation is consistent with theory and also whether the case law suggests that a court would, in fact, penalize those parties who made such a change. Alternatively, some respondents explained that they did not modify the contested contractual language because the bond market penalizes changes in contractual boilerplate. Here again, we look for parallel theoretical explanations and test whether it is the case that bonds with revised contract clauses suffer a pricing penalty on the market.

We begin with a description of the case that led to the drama over the meaning of a key standard clause in sovereign debt instruments.

Elliott v. Peru: Brussels, September 26, 2000

September 26, 2000, in a commercial court in Brussels, Belgium, a judge issued a ruling on what she surely thought was a routine preliminary injunction. That ruling became the catalyst for some of the most radical and far-reaching proposals for reform of the international financial system. Prior to the ruling, sovereigns were seen as largely enforcement-proof. Unpaid creditors could obtain judgments, but collecting on them was nearly impossible. The preliminary injunction granted by the Brussels judge turned out to have real bite, however, in part because it allowed for the possibility of a creditor going beyond the sovereign debtor and attacking other creditors who might have received payments from the sovereign. This was one of the first occasions in the centuries-long history of the sovereign debt market that creditors had succeeded in using a court decision, rather than political pressure or gunboats, to force a defaulting sovereign to pay its debts.

The ruling was ex parte—meaning that only the plaintiffs were heard on their side of the case—and it granted an injunction against the Brussels-based financial clearinghouse, Euroclear. The injunction barred Euroclear from crediting funds given to it by the Peruvian government to holders of Peru's restructured Brady bonds. Under the terms of the restructuring agreement, Peru undertook to pay only those bondholders who had agreed to a modification of Peru's obligation on the bonds. Elliott Associates, a hedge fund holding some Peruvian debt, had refused to enter the restructuring agreement. Now as Peru was preparing to pay the holders of the restructured debt through Euroclear, Elliott sought the preliminary injunction to bar the payments from being made. Elliott argued to the court that since its debt contracts included a term commonly designated as a pari passu clause, Peru was barred from making payments to the holders of the restructured bonds without also making proportional payments to Elliott.

The pari passu clause has been a standard provision in sovereign debt instruments since at least the late nineteenth century. Our data suggest that, apart from the payment terms, it is one of the two oldest covenants in the modern sovereign debt contract, the other being the tax gross-up clause. The Latin translation for pari passu is "in equal step." But what does it mean for debt to be in equal step? According to almost all commentators at the time of the Brussels litigation, the answer was—not much. In the domestic bankruptcy context, the notion of being in equal step has meaning because creditors form a queue during liquidation. Those in equal step recover from the liquidation proceeds pro rata. But sovereigns cannot be liquidated. And without a liquidation event in which the assets of the sovereign are aggregated and paid out, it is unclear what, if anything, the pari passu clause means. One possibility, of course, is that pari passu means that the sovereign cannot offer assets to other creditors as security for their loans and thereby impair the chances that the earlier bondholders will not be paid. But this risk—that a sovereign's assets will be parceled out to other creditors—is the province of the "negative pledge clause," another standard clause in all bond contracts. So the question remains: What, if anything, does pari passu add to the restrictions on the subsequent actions of the sovereign that are not already covered by other clauses whose meaning is well understood? For purposes of this study, however, whether the clause makes sense in the sovereign context is not crucial (although it does add to the drama). Much ink has been spilt over that argument already. What is relevant is that the vast majority of the respondents we interviewed believed that the clause made little or no sense in the sovereign context. Yet, even though the clause presented a risk of litigation, they were unwilling to change it.

At the time of the Brussels litigation, some participants in the sovereign debt markets thought that the clause was an historical relic, harking back to a time where foreign sovereigns would grant earmarks of their revenues; that is, they would promise an interest in tax or customs revenues to subsets of creditors. Because these promises arguably did not fit within the definition of traditional security interests, they perhaps would not have been barred by the standard negative pledge clauses that were a common feature of sovereign bond instruments. Hence, commentators speculated that the pari passu clause might have been aimed at constraining the grants of these quasi-security interests. Others suggested that the clause had migrated from cross-border corporate documents, copied by the lawyers working on drafting the initial sovereign bond contracts of the modern era (in the i980s), who had not realized that such a clause was meaningless in the sovereign context.

Where some saw the pari passu clause as a relic or mere surplusage resulting from earlier drafting errors, Elliott saw opportunity. It argued that the clause, in all its Latin finery, was no relic but rather embodied critically important rights for certain creditors that could be asserted against other creditors as well as against the sovereign debtor. Given that the clause could not logically be referring to liquidation in the sovereign context, it had to be given a meaning that made sense. Elliott was implicitly taking advantage of a long-standing canon of contract construction that all clauses, especially terms in contracts among sophisticated parties, are presumed by courts to have substantive meaning. Sophisticated parties, after all, would only have provisions in their contracts that had functions and, therefore, understood meanings. The meaning in this case, Elliott and Andreas Lowenfeld, its eminent law professor expert, argued was that when the sovereign was in default on a payment, it could not make preferential payments to one creditor over another, not if those creditors were linked by a pari passu clause. That, in turn, meant that the clause was an intercreditor agreement: If some creditors accepted payments—say, under the terms of a restructuring agreement—when pro rata shares had not been paid to all the other creditors, then—and this is the important part—those creditors were vulnerable to suit by the unpaid creditors.

Professor Lowenfeld's affidavit, after noting that the leading practitioners had not articulated a clear meaning for the pari passu clause in the sovereign context, explained:

I have no difficulty in understanding what the pari passu clause means: it means what it says—a given debt will rank equally with other debt of the borrower, whether that borrower is an individual, a company, or a sovereign state. A borrower from Tom, Dick, and Harry can't say "I will pay Tom and Dick in full, and if there is anything left over I'll pay Harry." If there is not enough money to go around, the borrower faced with a pari passu provision must pay all three of them on the same basis.

Suppose, for example, the total debt is $50,000 and the borrower has only $30,000 available. Tom lent $20,000 and Dick and Harry lent $15,000 each. The borrower must pay three fifths of the amount owed to each one—i.e., $12,000 to Tom, and $9,000 each to Dick and Harry. Of course the remaining sums would remain as obligations of the borrower. But if the borrower proposed to pay Tom $20,000 in full satisfaction, Dick $10,000 and Harry nothing, a court could and should issue an injunction at the behest of Harry. The injunction would run in the first instance against the borrower, but I believe (putting jurisdictional considerations aside) to Tom and Dick as well.

The battle, then, was joined over the meaning of this otherwise obscure clause. Under ordinary circumstances, the battle would have been fought and resolved in the commercial court in Brussels. Peru's lawyers were sovereign debt specialists, the New York-based firm of Cleary Gottlieb Steen & Hamilton. They would have challenged the injunction, pointing out that Elliott was advancing an interpretation of the pari passu clause that virtually no one else in the sovereign market would accept: Whatever pari passu meant, if anything, almost no one believed it meant that a debtholder who had not accepted the terms of the restructuring could attack the payments that were subsequently made to consenting creditors. If such an interpretation were allowed to stand, it would undermine any efforts to restructure sovereign debt in the future—a prospect that threatened to destabilize the international financial system. Odds are that the Brussels court, even if sympathetic to Elliott's position, would have recognized that Elliott was seeking to establish a novel understanding of the relationship among the bondholders of sovereign debt instruments. Under those circumstances, the court would likely have been unwilling to offer a definitive judgment on the meaning of a clause in a contract that was governed by New York law. But the circumstances were not ordinary.


Excerpted from The Three and a Half Minute Transaction by MITU GULATI ROBERT E. SCOTT Copyright © 2013 by The University of Chicago. Excerpted by permission of THE UNIVERSITY OF CHICAGO PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Meet the Author

Mitu Gulati is professor of law at Duke University. Robert E. Scott is the Alfred McCormack Professor of Law and the director of the Center on Contract and Economic Organization at Columbia Law School.

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