Why Buying a Bond is Like Signing a Contract: How “Contract Theory” is Integral to Investing

Oliver Hart contract theory
Oliver Hart November 16, 2017

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Contracts are an integral part of life. Many of our daily interactions include either a verbal or written contract. What contract is implied when you buy/sell investments?

Oliver Hart, Nobel Prize winner and Economics Professor at Harvard University, explains “contract theory.” He defines what a contract is and how people enter into agreements. Listen to their discussion of bond contracts and other investment agreements that require a contract.

Why do people frequently sign contracts that they may not fully understand? They also dive into the legal enforcement of contracts and the problems a contract can cause for both parties.

Is your current bank or brokerage firm providing the services you need?

Doug shares the story of a client who set up a U.S. investment account through his Israeli bank. He points out the folly of this decision (from an American tax point of view) and where the bank might have gone astray wrong with its financial planning models.

To learn more about how to plan a bond ladder, watch this short video, Learn How to Make a Bond Ladder.

If you’re not sure your current brokerage firm is giving you the service you need, watch U.S. Brokerage Accounts for Non-U.S. Residents.

To follow Professor Oliver Hart visit his website.

If you’re not already receiving updates on new episodes, sign up now, and as a special bonus, receive Doug’s free ebook The Retirement Planning Book.

Note, Doug is an investment advisor and does not give tax or pension advice.

Watch Why Buying a Bond is Like Signing a Contract: How “Contract Theory” is Integral to Investing on YouTube.

Read the Transcript

Interview with Oliver Hart

Professor Oliver Hart is a professor of economics at Harvard University and winner of the 2016 Nobel Prize in Economics for his work in Contract Theory. Who should write the contract, and must you read the contract every time?

Douglas Goldstein: I’m very excited to have on, The Goldstein on Gelt Show, Oliver Hart, professor of economics at Harvard University. He’s been there since 1993 and in 2016, he won the Nobel Prize in Economics for his work in contracts.

Not All Contracts Are Equal

Professor, I deal in contracts a lot in my day job as a financial advisor, things like new account documents, the client’s side, and options contracts. But I have a feeling that the type of contracts that you have studied are not exactly that.

Oliver Hart: Doug, the kind of contracts you’re talking about are in the category of the things I study, but there are contracts that I find more interesting. Let me first say that contracts are everywhere in the world and particularly in economic life.

Even with the simplest transaction, where you go into a store and buy something, there’s a contract behind that because you’ve agreed to buy the good and they’ve agreed to sell it, and you’ve agreed to pay whatever price they posted.

Things get more interesting when time is involved. For example, if I borrow money from you, you hand over the money now but you obviously are expecting me to repay later. Without some sort of contract that can be enforced, you might be wary that I will disappear or I’ll just refuse to pay.

I’m interested in debt contracts, insurance contracts, and contracts between firms, and they are a bit more complicated than the option contracts you’re talking about.

Optimal Contracts

Douglas Goldstein: What you just described before was a bond contract. When a client buys a corporate bond, frankly I don’t think they ever read the contract or see the contract, but there is a document that describes what the obligations are of both sides.

Oliver Hart: Absolutely. And if the firm gets into trouble and doesn’t repay, then what happens is very important and that’s written into the contract, or it could be part of bankruptcy law.

The fact is that there’s some sort of enforcement ability there. The firm cannot simply say, “I promised you a certain amount of money and now, sorry, I’ve changed my mind.” They can’t do that. You have some recourse in that situation.

I’m interested in the optimal contract. What’s the best kind of contract to write in a situation like that?

Who Should Write the Contract?

Douglas Goldstein: Isn’t it always the question of who’s writing the contract? You always want to be the one who writes the contract when you’re getting involved in a deal, so presumably, if a client’s buying a bond, and the company issued the contract, then the company has the benefit in that negotiation.

Oliver Hart: It’s very interesting you say that, because economists don’t look at it that way, and that’s one of the important things about economics.

Economists tend to think about contracts as maximizing the total size of a pie, so it’s not really the company trying to take advantage of the customer.

If the company writes a contract that is very disadvantageous to the customer, then presumably the interest rate that the customer would require would be higher in that kind of situation. The company can’t dictate the terms and keep the price constant.

The worse the terms are for the person holding the bond, you compensate them in some way, say, with a higher interest rate.

It’s in your interest, as the person writing a contract, to write a good one so that you’re not hurt by the other side. To give another example, if I’m a firm and I sell you a product with a very poor warranty, or a guarantee in some countries, if anything goes wrong, it’s going to be your problem not mine.

If people on the customer side are rational, they’re not going to pay as much for a product like that. As the firm selling the product, it may well be in my interest to provide a very good warranty because I can charge a higher price.

Douglas Goldstein: That sounds more like a marketing issue. Like you’re describing, in other words, the company figures with or without a warranty, they can either charge more or charge less. And it’s a business decision, not necessarily maximizing the total size of the pie as you said.

Oliver Hart: That’s a very good point, but in fact it turns out that the two things become equivalent. It’s a bit like Adam Smith. When he talked about businesses making money, he pointed out that if there was competition, they would end up doing good to society even though that wasn’t their intention at all. The same is true here.

If you’re going to write a contract, the contract that is best for the firm, assuming that the customer on the other side understands what’s going on, that is also going to be the contract that maximizes the total surplus.

We Make Assumptions When Signing Standard Contracts

Douglas Goldstein: Professor, it seems to me that in the financial world, like you mentioned, where contracts are so important, there is always an assumed contract.

We’re talking about this idea of bonds and bond contracts, and in the 25 years I’ve been doing this, I don’t think I’ve ever had a client who said to me, “Could I see the actual debt instrument that I’m buying?”

It seems to me that people have a huge amount of trust. I’m wondering where that comes from, and is it justified or should people be trying to get everything down on paper?

Oliver Hart: A lot of the contracts that people sign are complicated, and people sign without reading them carefully. I think it’s true if you just think about the products we buy in the marketplace, particularly high-tech sorts of things.

There can be very complicated terms to the contract. These days, when you buy something online, sometimes you must check a box saying, “I accept all the terms.” It’s the same thing you do, even when you go to a hotel and get wireless internet.

Douglas Goldstein: Do you check the box when you go to a hotel?

Oliver Hart: I do, otherwise I would be spending the whole hotel stay reading the contract, and that’s not quite the point of my vacation or whatever it is.

I tick the box and assume that I’m not entering into something terrible, like that I owe them $1 million.

I assume that because everybody else is doing this, because it’s a standard form, it’s not personal to me, and that if there was a problem, there’d be some sort of class action suit, or some regulator would step in, or the courts would step in.

When Must You Read the Small Print?

Douglas Goldstein: Is that a legitimate position for someone to have? In other words, people go on vacation and don’t want to spend all day reading the contract. But when they go to a bank or brokerage firm to open an account, they assume that the contract is reasonable.

Is that fair for someone to assume, and therefore he can’t later sue and say, “I didn’t know there was a pre-arbitration clause in your contract?”

Oliver Hart: I think for the small transactions that I’m talking about, accepting Wi-Fi, and that kind of thing, it’s fine. But if you were doing something more serious, you would be well advised to read the contract.

For example, when you’re taking a job and the terms of employment in the contract say that if there’s a problem, it will go to binding arbitration, you might want to know whether you’re agreeing to a covenant not to compete.

That would be extremely important if you later found out that you want to leave and get another job, but then the employer points out that you can’t do that. That’s something you should have known from the get-go. It all depends on the size and importance of the contract.

Douglas Goldstein: Are you saying it’s not a legitimate position in a larger contract, say, a work contract, to later come back and say, “Well, I didn’t really understand what the non-competing meant. I didn’t understand that I couldn’t go into the same business as you?”

Oliver Hart: I don’t think the courts would be very sympathetic to that, certainly in the United States.

Important Parts of the Contract Should Be Highlighted

This is not what my work has been about up to now, but I think it’s a very important issue. To what extent should people be required to flag things like that in their contract?

You can have a contract with hundreds of pages and it could be buried in small print that you’re signing your life away. That wouldn’t be good, and I think that there’s a very strong argument for regulators to intervene, or the courts to refuse to enforce a contract like that because you should have made it completely clear to Doug that he was signing his life away; it should have been in large letters.

I think that’s a reasonable approach, and we should perhaps be moving more in that direction. But at the same time, I don’t think, assuming I’ve pointed it out to you that there’s this covenant, I don’t think it would be reasonable for you to say,” Yes, I saw it but I had no idea what it meant.” That is not a good defense.

Douglas Goldstein: It’s interesting, what you’re saying about putting it in bold, and I’m thinking now about the contract I mentioned before; the new account form that a client signs when he opens an account.

There are sections that are written in bold, or important parts we ask the clients to initial, specific sections to demonstrate that he read page six of the contract. Is that what you’re talking about?

Oliver Hart: Yes. Things like that. It should be part of the communication. If you’re sitting there in front of the person, there should be some discussion that takes place.

Important Contracts Tend to Be Wordy

Douglas Goldstein: I think the problem is that the lawyers get so excited about writing these documents that I feel as an advisor, I explain to the client, the risks and the costs and what’s going on, and then the compliance officers who write these documents, this is all they do. So they’re the ones who come up with hundreds of pages that you’re referring to, say, in the mutual funds prospectus. Do they do this because they think it binds the clients?

Oliver Hart: Yeah. I’m puzzled as much as anybody as to why these contracts must be so complicated, and why some of the language is so complicated.

I don’t rent apartments anymore, but one of my sons has done so, and I looked at the lease he was signing and I couldn’t understand parts of it because the language was extremely old-fashioned.

I don’t think that’s a good situation. I think we should be trying to move towards a situation where the main elements can be explained using simple language.

Should Contracts Be Legislated?

Douglas Goldstein: I will ask the political question which is, do you think that should be enforced through legislation, or the courts should be more reasonable about how they enforce contracts?

Oliver Hart: I would be in favor of both. I think there is a strong argument for saying to the person who drafted the contract that if they don’t make some effort to explain what it all means to the other person, then the more obnoxious parts shouldn’t be enforced.

Another thing that we see these days that worries me is the amount of stuff that is confidential. You have these settlements, and when people settle things, they often must agree not to say anything about what’s happened.

I respect freedom of contract. If you and I sign a contract which says that neither of us can talk about what’s in it, my first thought is, why shouldn’t we do that if that’s what we want to do?

But sometimes there is a public policy aspect of this, and I think for the rest of society it would be good if we knew what happened.

If an employer abuses an employee or sexually harasses her, I’m not sure that that’s the sort of thing that should be kept quiet.

I can imagine regulators and the courts moving to a situation where they say, “No, we won’t enforce that agreement to stay quiet.” However, we haven’t got there yet.

Contracts Can Be Kept Private

Douglas Goldstein: I’m inclined to agree with you that when people enter into a deal with open eyes, they should be allowed to make the terms that they want, assuming one side isn’t taking advantage of the other side, who may simply be incapable of handling a contract. But when two grownups get together and make a deal, it seems fair that they should be able to choose whether it’s private or public.

Oliver Hart: If A sexually harasses B, do you think it’s okay if A agrees to pay something to B for the harm done and then B agrees not to talk about it?

Douglas Goldstein: If there is a criminal case, then the police should be involved. But if there’s no criminal case, if they come to an agreement, A might simply pay what is worth for B.

Oliver Hart: I’m not sure about that. I think there’s some spillover to the rest of society from all the secretiveness.

You’re taking a more respecting the contract position than I am, and I am not sure about this. I can see in the future we might be moving in my direction, where things are more public.

Douglas Goldstein: I’m from the People of the Book, and we are very serious about what the original contract says.

In Jewish tradition, we have the Bible, which is the written law, and then we have the Talmud, which is the oral law. The Talmud is the case law that was discussed and came into effect over thousands of years until today, and people still study it.

I think it seems that there’s room, like you’re saying, for two sides. There’s the actual written contract, that is the law, and there’s the development of the interpretation over the years.

Oliver Hart: That’s getting a little far, and I have to think about that.

Douglas Goldstein: We’ll bring you back on that next time. Professor, tell me in the last few seconds, how can people learn more about the work you’re doing?

How to Follow Professor Oliver Hart

Oliver Hart: They could visit my Harvard website. Whether you will find anything that will be helpful to you, I don’t know, but you could try. I welcome visitors.

Douglas Goldstein: I understand that there are no promises and there are no contractual obligations that you are signing yourself to if people come to your site. Thanks so much for taking the time, Professor.

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