Harvard Law School’s Private Law Workshop: Oren Bar-Gill & Ariel Porat, Disclosure Rules in Contract Law

Post by Patrick Goold

Caveat emptor, or buyer beware, was the traditional principle of Anglo-American contract law. Today, however, many common law jurisdictions require the seller to disclose material information to the buyer prior to sale. Nevertheless, the duty to disclose is still subject to debate. Should the law obligate the seller to disclose pertinent information (a mandatory disclosure rule)? Or should disclosure be at the discretion of the seller (a voluntary disclosure rule)? In Disclosure Rules in Contract Law, Oren Bar-Gill and Ariel Porat study how mandatory and voluntary disclosure rules affect sellers’ incentives to invest in pre-sale investigation of goods. Speaking at the final installment of this year’s Private Law Workshop, Oren Bar-Gill explained their conclusion: that mandatory disclosure rules typically, but not always, provide sellers with efficient incentives to acquire socially valuable information regarding the asset.  

Imagine the following example. Having lived in a house for 10 years, the owner suspects there is water beneath the house that might damage its foundations. Before selling the property, the owner could hire a surveyor to investigate whether underground water exists. Whether hiring a surveyor is efficient depends on the value of the information investigation reveals relative to the cost of acquiring it, i.e. hiring the surveyor.

In 1994, Steven Shavell studied how mandatory (MD) and voluntary disclosure (VD) rules affected the incentives of sellers to undertake such investigations. Shavell found that MD rules create efficient incentives, while VD rules do not. If the owner knows that any information the investigation reveals must be disclosed, then he will only invest in the investigation if the expected increase in value to the asset outweighs the cost of the investigation. Conversely, voluntary disclosure rules cause owners to invest too heavily in information-acquisition, on the grounds that any favorable information can be used to demand a higher price, while unfavorable information is simply ignored.

However, Shavell’s model assumed the seller and buyer have symmetrical information, i.e. they both have equal knowledge about the likelihood of groundwater under the house. But in many situations information is likely asymmetrical. In the example above, it is likely the homeowner knows more about the probability of groundwater than the buyer. Accordingly, Bar-Gill and Porat examine the seller’s incentives to investigate in cases of asymmetric information.

Bar-Gill and Porat find that when asymmetrical information is taken into account MD rules still typically provide more efficient incentives than VD rules, but not as often Shavell’s analysis predicts. In the example above, where the seller has reason to believe the likelihood of underground water is high, the seller will investigate too little. This is because, for owners with such “negative priors,” investigation is likely to reveal unfavorable information that, given an MD rule, will have to be disclosed, and which will reduce the price of the asset, even when the social value of the information is high. Conversely, sellers with “positive priors” (i.e., where the likelihood of the underground water problem is low) will too frequently investigate, resulting in wasteful expenditures, because, for them, the information they obtain will likely reveal favorable information allowing them to charge a higher price for the asset. Nevertheless, despite the fact that MD rules can lead to these inefficiencies, they typically still provide better incentives than VD rules. VD rules result in owners with both good and bad priors over-investing. The extent of inefficient over-investigation caused by VD rules generally outweighs the range of inefficient investment decisions caused by MD.

Bar-Gill and Porat also introduce a third rule: the mandatory post-contractual disclosure rule (MPCD). This rule would require disclosure of material information, but only after the contract is concluded (and once divulged, would not permit a cancellation of the contract). The MPCD rule would provide incentives to investigate that are stronger than those provided by MD rules but weaker than those provided by VD rules and thus under certain circumstances might best promote efficiency.

The Harvard Law School Private Law Workshop will return again in Fall 2017.

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