Reading the fine print in agricultural contracts: conventional contract clauses, risks and returns.

One distinguishing feature of ongoing structural change in agriculture is increasing vertical coordination between agricultural producers and processors, much of which has come through agricultural production and marketing contracts. Agricultural economists, extension agents, legal aid groups, and others have sought to provide farmers with information that enables them to make informed decisions regarding contract use. While all sensible advice begins with suggesting that a farmer consult his or her attorney and accountant before signing, numerous outreach publications provide information regarding specific contract provisions. (See, for example, Holman, Feuz, and Baltensperger 2006; Kunkel and Larison 2006; Office of the Illinois Attorney General 2005.)

In contrast to the relatively comprehensive analysis in such outreach efforts, agricultural economists' theoretical analyses of specific agricultural contract provisions have tended to focus on contractual provisions regarding compensation, and, to some extent, on input provision. When comparing the average theoretical model to an actual agricultural contract, there are pages of the contract that do not appear in the model at all.

Much of the material omitted in theoretical analyses of agricultural contracts is "boilerplate." Boilerplate is standardized contract terms that are used in multiple contacts. These terms are usually not subject to bargaining and typically are presented on a "take it or leave it" basis (Farnsworth 2001). Boilerplate reduces risk for the drafting party in several ways: economies of scale allow greater care and expertise to used in drafting, boilerplate typically states which states' law will apply, and boilerplate reduces uncertainty about judicial interpretation by using language already tested in that state's courts. But boilerplate can work to the disadvantage of the other party. To an extent constrained by competition and law, boilerplate will usually be drafted to the advantage of the drafter (Farnsworth 2001). The non-drafting party is usually relatively unfamiliar with the form and may have little opportunity to review it thoroughly. Boilerplate has been characterized as "at least formulaic, probably legalistic, and possibly unfair" (Bast 1994).

Most people know boilerplate from consumer sales contracts. But it is also used in contracts between large, sophisticated commercial parties, such as auto manufacturers and parts suppliers (Ben-Shahar and White 2006). And it plays a prominent role in agricultural contracts. We discuss four types of boilerplate provisions and their implications for farmers' returns and risks: the treatment of farmers as merchants, arbitration and mediation clauses, warranties, and legal and regulatory compliance clauses. We then explore potentially fruitful directions for future research. Our discussion draws on the law and economics literature regarding boilerplate. Due to space limitations, we do not examine other related work, some of which will be addressed elsewhere in this session.

We motivate our discussion with examples of boilerplate provisions from specific agricultural contracts. We limit our examples to publicly available contracts. While in many instances this means that the quoted contracts are no longer in effect, confidential review of other, more recent, contracts suggests that the quoted material is still relevant, as are terms of recent contracts included in this discussion. Our selection of examples is in no way intended to be a statistically valid sample: while such a sample would be ideal, it is not available. Our more modest goal is to provide illustrations of contract terms in use and some guidance regarding their value.

Farmers as Merchants

The Uniform Commercial Code (UCC) introduced the concept of holding merchants to higher standards than consumers into U.S. law in the 1970s (Farnsworth 2001). Most states have adopted the UCC with minor variations. The UCC defines a merchant as:

A person who deals in goods of the kind or

otherwise by the person's occupation holds

that person out as having knowledge or skills

peculiar to the practices or goods involved in

the transaction. UCC[section]2-104(1).

Merchants are presumed to be knowledgeable regarding the implications of contract terms. Consumers are presumed to be relatively uninformed regarding the implications of standard legal clauses, and often to have not even read them (Gilo and Porat 2006). Merchant status is important because it removes some statutory protections provided consumers (National Agricultural Law Center 2006).

Jurisdictions vary widely on farmers' status as merchants (National Agricultural Law Center 2006). Some courts have ruled that farmers have specialized expertise, while others have defined specific conditions under which farmers are merchants (Hamilton 1995). Section Two of the UCC applies to sales of goods, but not services, yet some jurisdictions define it to apply where the contractor retains title to the crop or livestock (Hamilton 1995). Some contracts contain explicit statements about farmers' status as merchants:

GROWER and DuPont Specialty Grains

are experienced and knowledgeable in the

cultivation of corn and business transactions

involving corn. DuPont Specialty Grains

(2001)

Merchant status can significantly affect the outcome of a contract dispute. Merchants are expected to be familiar with the meaning of contract terms as well as basic contract law provisions, such as conditions under which oral agreements are binding. Merchant status can affect how a court rules on the "unconscionability" of a specific contract provision. Courts may refuse to enforce unconscionable contract provisions or contracts containing them (Farnsworth 2001). Courts have tended to interpret unconsionability as requiring both procedural unfairness, such as "unreasonably hard-to-read print," and substantive unfairness that noticeably favors one party (Swanson 2001).

In economic analysis of agricultural contracts, merchant status can be modeled as a full rationality actor with full information. Consumer status can be modeled as a rational, but not fully informed, economic player. This modeling choice can have important consequences for evaluating policy options. For example, the social value of regulations intended to level the informational playing field depends on whether or not there is an information asymmetry in the first place.

Recent legislation suggests recognition that some growers may not have the knowledge and sophistication of the larger entities with whom they are increasingly entering long-term production contracts. For example, Illinois Public Act 93-522, implemented in 2005, safeguards growers against unfair contracting practices and facilitate their understanding of contract terms (Office of the Illinois Attorney General 2005). Requirements such as the readability requirement of a Flesch-Kincaid Grade Level score of twelfth-grade level or lower suggest that lawmakers did not consider growers to be merchants. The requirements also can be interpreted as prohibiting some types of procedural unfairness that can contribute to a ruling of unconscionability.

Dispute Resolution, Arbitration, and Mediation

Dispute resolution clauses specify how the parties will manage disagreements. Choice of law and venue provisions decrease uncertainty for contractors, but may increase it for growers who may find themselves governed by unfamiliar state law. Arbitration and mediation provisions require parties to rely on a neutral third party as part of an alternative to the court system. Under arbitration, the parties agree that the decision of the arbitrator(s) will be final. Under mediation, the decision of the mediator(s) is not binding, and either party can pursue the matter in court. At a minimum, arbitration and mediation clauses specify who will arbitrate or mediate, who will pay the associated fees, and, in the case of mediation, whether or not it must be attempted prior to a court filing:

The parties agree to the use of mediation to

attempt to resolve any dispute between the

parties arising out of or relating to this Agreement.

The mediator shall have no authority

to impose a settlement of any such dispute.

Jennie-O Turkey Store, Inc. (no date)

Optimum and GROWER agree that all disputes

and differences arising between Optimum

and GROWER out of or relating in

any way to this Agreement, the construction,

meaning and operation of this Agreement, or

breach thereof, shall be settled in arbitration

in accordance with the rules and regulations

of the National Grain and Feed Association

pursuant to such Association's grain arbitration

rules. Optimum Quality Grains, L.L.C.

(2000)

While arbitration and mediation were originally advocated as ways to decrease dispute settlement costs, there are ways in which they may increase costs for one other party. The standard rule in U.S. civil litigation is that each party pays their own litigation costs (Dobbs 2000). Some arbitration clauses require the losing party to compensate the winner for the costs of the arbitration.

Any dispute under this Agreement shall

be resolved by arbitration in Santa Ana,

California pursuant to the rules, then obtaining,

of the American Arbitration Association

and the prevailing party shall be

entitled to reasonable attorney's fees and all

costs. Calavo Growers, Inc. (2003)

A provision such as the one above may increase the expected cost of pursuing a grievance. Another contract provides a more extreme example of a dispute-related clause increasing expected costs:

Grower shall pay on demand all costs and expenses

incurred by Murphy in enforcing or

protecting its rights and remedies hereunder,

including, but not limited to, reasonable attorneys'

fees and legal expenses. Murphy Family

Farms, Inc. (no date)

Dispute resolution clauses affect the cost of a "bad" outcome. While in some cases mediation and arbitration may be cheaper than a lawsuit, in others they can increase costs, especially if mediation is followed by a lawsuit. Provisions requiring the grower to pay any costs incurred by the contractor, such as the one above, can make a dispute costly for the grower regardless of whether or not he prevails. Binding arbitration can increase the riskiness of the outcome since there are very limited grounds for appeal from binding arbitration and courts have recently upheld agricultural contract arbitration clauses (Sleeper Farms v. Agway, Inc., summarized in Pittman, 2006).

Warranties

Boilerplate frequently seeks to modify statutory or common law warranties or to create new warranties affecting the two parties or their obligations to third parties. These warranties or warranty disclaimers commonly deal with the quality of delivered goods or parties' compliance with federal, state, and local laws and regulations.

The UCC, and most common law, includes an "implied warranty of merchantability," that is, goods sold by merchants are implicitly warranted to be suitable for their intended purpose. Parties can disclaim these warranties, as in this export production agreement for high oil corn:

Dupont specialty grains makes no warranties

of merchantability or fitness for a particular

purpose of any other express or implied

warranty. No claim of any kind, whether or

not based on negligence, shall be greater in

amount than the value of commercial seed in

a quantity comparable to that quantity of seed

subject to this agreement. DuPont Specialty

Grains (2001)

Contracts sometimes include other disclaimers. The following clause seeks to protect the contractor from liability if a grower is harmed by relying on information provided by the contractor.

ConAgra will provide to the Grower broiler

growing facility and equipment requirements,

in writing, as a service, and not as a representation

that the plans and specifications for

the housing or equipment contained therein

are free from any error, nor does ConAgra

give Grower any warranty whatsoever with

respect to such plans and specifications.

ConAgra shall have no liability, direct or

indirect, expressed or implied, to Grower

for any error or omission appearing in

such plans and specifications for the design,

construction, materials, equipment, quality,

installation or workmanship of all or any

part of the growing facilities or equipment.

ConAgra Broiler Company (no date)

As the quoted provisions indicate, warranties and warranty disclaimers in agricultural contracts are designed to protect the interests of the one who drafted the contract. Excluding a warranty on seed or other contractor-supplied inputs increases the riskiness of the grower's net returns and lowers his expected return, because he may not be able to recover costs from the contractor in the event of a production failure due to poor input quality. The economic efficiency of such provisions will depend on a number of factors including the ability of the contractor to distinguish between an input-induced production failure and a grower-induced production failure.

Legal Compliance and Liability

Contract provisions are also used to reduce the risk that one party's failure to comply with federal, state or local law will affect the other party. Warranties of compliance provide one approach, as in the following two examples. The first provides a very general warranty.

Grower warrants that the avocados have been

grown and harvested in conformity with all

applicable federal, state and local laws and

regulations. Calavo Growers, Inc. (2003)

The second example is a much more specific warranty.

Grower agrees to conform to (i) the provisions

of the pure food and drug laws and

other present or future laws of the State of

California, and (ii) the provisions of the Federal

Pure Food and Drugs Act of the United

States of June 30, 1906, and all amendments

thereto. Grower warrants that walnuts delivered

under this contract will not on the date

of delivery be adulterated or misbranded

within the meaning of any applicable law of

the State of California, or the Federal Food,

Drug, and Cosmetic Act. Grower further

warrants that the walnuts have not been

subjected to any pesticides or chemicals that

may detrimentally affect the natural state of

such walnuts, or the saleability thereof. All

products delivered hereunder will be produced

in compliance with the requirements

of section 12 of the Fair Labor Standards

Act of 1938, as amended, and all other

requirements of the Act so far as they may

be applicable. Diamond Foods, Inc. (2005)

Other contract provisions require the grower to indemnify the contractor against liability in the event that the grower is found to have violated a law or regulation, or require the grower to keep records regarding his compliance with specific laws and regulations.

Provisions regarding legal and regulatory compliance may take a number of forms, and economic implications will differ, based on the specific situation. Focusing on environmental regulation, Vukina (2003) concludes that the optimal division of environmental compliance costs depends on many factors, such as operational scale and contract terms regarding compensation. Differences in bargaining power may lead to inefficient outcomes, as when contractors attempt to impose full liability for environmental violations on growers when the growers are not the least cost compiler.

Boilerplate can be used to clarify the legal relationship between the contracting parties. For example, it is common for contracts to portray the grower as an independent contractor rather than as an employee of the contractor. One reason to define the relationship in this way is to protect the contractor from liability associated with the grower's actions taken while fulfilling the contract. The use of such provisions has a long, hotly debated, history of use in farm labor relations. Courts have generally looked beyond the contract provisions to examine the material relationship between the parties, for example the extent to which the farm laborer controls their own work hours, performance, and supply of equipment and materials. Boilerplate that explicitly address liability may also be included:

You agree to fully indemnify and hold us

harmless against any and all loss, liability,

damage, and expense arising out of your default

or in your failure of obligation to your

employees or agents. Jennie-O Turkey Store,

Inc. (no date)

Warranties regarding compliance, the definition of the legal relationship, and liability clauses all affect distribution of risk and outcomes if governing law is violated.

Economic Implications of Boilerplate and Future Research Directions

Boilerplate is specifically used by drafters to reduce legal uncertainty and affect the distribution of risks and returns from agricultural contracts. How, in turn, should these implications influence the economic analysis of these contracts? One purpose of economic analysis is to assess the efficiency and distributional effects of proposed and implemented policies, so one way of identifying directions for future research is to examine current events in the policy arena.

Recent and ongoing lawsuits regarding environmental regulatory compliance and growers' status as independent contractors illustrate the limitations of boilerplate. In Sierra Club v. Tyson Foods (2003), the court specifically rejected Tyson's claim that a growers' independent contractor status absolved Tyson's of responsibility for reporting related to the growers' activities under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA). The court cited the substantial degree of production control exercised by Tyson, as well as its ownership of the chicks. A related federal case, State of Oklahoma v. Tyson Foods is still pending (Peck 2005).

Slaughter (2006) speculates that contractors may choose to forego some control of the production process to try to avoid liability for environmental violations. In Sierra Club v. Tyson Foods, the court rejected boilerplate designed to eliminate contractor liability, and tied responsibility for environmental compliance to responsibility for production. The impact of trade-offs between production control and environmental liability on contractors, growers, and social welfare is a critical area for future research.

We now consider broader questions regarding the implications of the changes in risks and returns due to boilerplate for the analysis of agricultural contracts. For purposes of discussion, we assume that the farmer and the contractor are both fully informed, and have a classic risk-neutral principal (contractor), risk-averse agent (grower) relationship. Our first observation is that provisions that impose the costs from a bad outcome on the grower instead of on the contractor are simply reflected in the contractor's optimal contract choice. In contrast, provisions which impose costs on the grower that are not a benefit to the contractor; such as the costs of a dispute resolution process, need to be introduced explicitly into the analysis. Under a simple effort provision model where the probability of a successful outcome increases with grower effort, such costs will reduce the grower's effort, and the probability of a successful outcome, under the optimal contract. However, the contractor's profits may actually increase, depending on parameter values and the properties of the effort-probability of success function and utility function. Exploring the applicability of this result to more general models, and to models of specific contract types, is an area for future research.

We next consider the effects of provisions that increase the riskiness of grower returns, e.g., provisions disclaiming all warranties on inputs supplied by the contractor. The variance of returns, often used to analyze risk, may not correctly represent the effect of warranty disclaimers. Such provisions increase "downside" risk, but do not provide any off-setting "upside" risk. Without a warranty disclaimer, the distribution of grower's returns first-order stochastic dominates a contract with the same parameters and a warranty disclaimer. Hence, if a contractor wishes to introduce a warranty disclaimer into a contract that provides the grower with precisely enough utility to meet his individual rationality constraint, the contractor must increase the grower's returns by adjusting other contract parameters. Furthermore, because introducing a warranty disclaimer into a contract reduces the insurance provided to the risk-averse grower, the grower's optimal effort level will decline. Presumably, the contractor must receive benefits from a warranty disclaimer that offset these costs.

There are at least three possible types of benefits for the contractor. First, the contractor may be risk-averse, so that he obtains an insurance benefit by shifting risk to the grower. Second, a warranty disclaimer protects the contractor from being assessed damages greater than the value of the inputs provided to the grower. Damages could be based on the estimated value of the lost output, or could include attorneys fees and court costs. Under the correct facts, growers might even seek punitive damages. Future research could examine the implications of boilerplate regarding attorneys fees and court costs on efficient effort and care taking, another possible direction is integration of the recent law and economics literature on punitive damages with the agricultural contracts literature. Third, there may be incentive effects that the contractor can utilize to increase his profits. One interesting question is whether the incentive effects of warranty disclaimers alter or refine current findings in the agricultural contracts literature. For example, Goodhue (2000) demonstrates that contractor provision of non-labor inputs reduces information rents due to an adverse selection problem and increases contractor profits. To the extent that the probability and severity of bad outcomes are dependent on both factors that would be covered by a contractor warranty and grower type, the reduction in information rents would be smaller under a warranty disclaimer, as would the increase in contractor profits. Whether or not the increase in profits could be reversed is a question for future research.

Another interesting area for future research would be linking the type of policy analysis presented in Schieffer and Wu (this issue) to the law and economics literature regarding boilerplate design. MacLeod (2006) evaluates the relative efficiency of contractual incentives and relational incentives as a function of the costliness and quality of the legal system, the seller's control over product quality, and other factors. In both analyses, the focus is on the relative strengths of formal and informal mechanisms.

Future research in this new and exciting area could be further enhanced by tying it to research that focuses explicitly on the design of boilerplate. Davis (2006) offers the possibility that non-profits can mitigate the need for government intervention in contract design. He argues that boilerplate provided by trade associations or other non-profits can internalize externalities that may not be recognized by law firms or other for-profit entities, and that nonprofits can benefit from members' knowledge of and experience in the industry in question.

Conclusion

Like other legal contracts, most terms in agricultural contracts are standardized provisions called boilerplate. Strategic choice of such clauses can increase a principal's returns. However, these same clauses can lower the returns and increase the risk of less sophisticated agents. With contracting becoming a prominent means of coordinating U.S. agricultural production, it is important that agricultural economists focus on the theoretical and empirical implications of boilerplate for farmers and the U.S. public.

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Rachael Goodhue is associate professor in the Department of Agricultural and Resource Economics, University of California, Davis, and a member of the Giannini Foundation of Agricultural Economics. Sandra Hoffman is fellow, Resources for the Future.

This article was presented in a principal paper session at the AAEA annual meeting (Long Beach, CA, July 2006). The articles in these sessions are not subjected to the journal's standard refereeing process.