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An option contract is a type of contract that protects an offeree from an offeror's ability to revoke their offer to engage in a contract.
Consideration for the option contract is still required as it is still a form of contract, cf. Restatement (Second) of Contracts § 87(1). Typically, an offeree can provide consideration for the option contract by paying money for the contract or by providing value in some other form such as by rendering other performance or forbearance. See consideration for more information.
An option is the right to convey a piece of property. The person granting the option is called the optionor (or more usually, the grantor) and the person who has the benefit of the option is called the optionee (or more usually, the beneficiary).
Options characteristically exist in one of two forms:
- Call options, which give the beneficiary the right to require the grantor to sell or convey the property to them at the agreed price on exercise
- Put options, which give the beneficiary the right to require the grantor to buy or receive the property at the agreed price on exercise.
Because options amount to dispositions of future property, in common law countries they are normally subject to the rule against perpetuities and must be exercised within the time limits prescribed by law.
In relation to certain types of asset (principally land), in many countries an option must be registered in order to be binding on a third party.
Application of option contract in unilateral contracts
The option contract provides an important role in unilateral contracts. In unilateral contracts, the promisor seeks acceptance by performance from the promisee. In this scenario, the classical contract view was that a contract is not formed until the performance that the promisor seeks is completely performed. This is because the consideration for the contract was the performance of the promisee. Once the promisee performed completely, consideration is satisfied and a contract is formed and only the promisor is bound to his promise.
A problem arises with unilateral contracts because of the late formation of the contract. With classical unilateral contracts, a promisor can revoke his offer for the contract at any point prior to the promisee's complete performance. So, if a promisee provides 99% of the performance sought, the promisor could then revoke without any remedy for the promisee. The promisor has maximum protection and the promisee has maximum risk in this scenario.
An option contract can provide some security to the promisee in the above scenario. Essentially, once a promisee begins performance, an option contract is implicitly created between the promisor and the promisee. The promisor impliedly promises not to revoke the offer and the promisee impliedly promises to furnish complete performance, but as the name suggests, the promisee still retains the "option" of not completing performance. The consideration for this option contract is discussed in comment d of the above cited section. Basically, the consideration is provided by the promisee's beginning of performance.
Case law differs from jurisdiction to jurisdiction, but an option contract can either be implicitly created instantaneously at the beginning of performance (the Restatement view) or after some "substantial performance." Cook v. Coldwell Banker/Frank Laiben Realty Co., 967 S.W.2d 654 (Mo. App. 1998).
It has been hypothesized that option contracts could help allow free market roads to be constructed without resorting to eminent domain, as the road company could make option contracts with many landowners, and eventually consummate the purchase of parcels comprising the contiguous route needed to build the road.
It is a general principle of contract law that an offer cannot be assigned by the recipient of the offer to another party. However, an option contract can be sold (unless it provides otherwise), allowing the buyer of the option to step into the shoes of the original offeree and accept the offer to which the option pertains.
In economics, option contracts play an important role in the field of contract theory. In particular, Oliver Hart (1995, p. 90) has shown that option contracts can mitigate the hold-up problem (an underinvestment problem that occurs when the exact level of investment cannot be contractually specified). However, there is a debate in contract theory whether option contracts are still useful when the contractual parties cannot rule out future renegotiations. As has been pointed out by Tirole (1999), this debate is at the center of the discussions about the foundations of the incomplete contracts theory. In a laboratory experiment, Hoppe and Schmitz (2011) have confirmed that non-renegotiable option contracts can indeed solve the hold-up problem. Moreover, it turns out that option contracts are still useful even when renegotiation cannot be ruled out. The latter observation can be explained by Hart and Moore’s (2008) idea that an important role of contracts is to serve as reference points.
- Restatement (Second) of Contracts § 25 (1981)
- See § 45 of Restatement (Second) of Contracts for the black letter law of the option contract's application to this situation.
- Benson, Bruce L. (2006). "Do Holdout Problems Justify Compulsory Right-of-Way Purchase". Street Smart: Competition, Entrepreneurship, and the Future of Roads. p. 65.
- John D. Calamari, Joseph M. Perillo, The Law of Contracts (1998), p. 707.
- Hart, Oliver (1995). Firms, contracts, and financial structure. Clarendon Press.
- Lyon, T. P.; Rasmusen, E. (2004). "Buyer-Option Contracts Restored: Renegotiation, Inefficient Threats, and the Hold-Up Problem". Journal of Law, Economics, and Organization. 20 (1): 148–169. doi:10.1093/jleo/ewh027. ISSN 8756-6222.
- Tirole, Jean (1999). "Incomplete Contracts: Where do We Stand?". Econometrica. 67 (4): 741–781. CiteSeerX 10.1.1.465.9450. doi:10.1111/1468-0262.00052. ISSN 1468-0262.
- Hoppe, Eva I.; Schmitz, Patrick W. (2011). "Can contracts solve the hold-up problem? Experimental evidence". Games and Economic Behavior. 73 (1): 186–199. doi:10.1016/j.geb.2010.12.002.
- Hart, Oliver; Moore, John (2008). "Contracts as Reference Points*". Quarterly Journal of Economics. 123 (1): 1–48. CiteSeerX 10.1.1.486.3894. doi:10.1162/qjec.2008.123.1.1. ISSN 0033-5533.