Template:Notification of default paradox

If a tree falls in a forest and no one is around to hear it, does it make a sound?

—Bishop Berkeley

Perhaps unwittingly, George Berkeley addresses the language-dependence of reality. For what no human ear registers cannot be articulated, and what cannot be articulated carries no weight in our ontology. One only articulates things one cares about — the world wide web seems to gives the lie to this, come to think of it — so, for something to matter, someone who cares about it must see or hear it.

So it is with contracts. There are two kinds of obligations: overt ones, that cannot help but announce themselves to someone who is on record as caring about them — payments, deliveries, the rendering of agreed-upon services — and implicit ones, private matters that can only be determined by enquiry — one’s good standing, license to do what one has undertaken, one’s solvency.

These latter obligations are generally oblique to the purpose of the contract: I don’t care exactly that you hold a licence to drive a taxi, I care that you are a competent driver and my journey will be safe. A licence is a basic proxy to save me making that enquiry. It obviates due dilly. Likewise, I may seek a certificate of good standing from the companies register.

What has this to do with trees in uninhabited forests? Well, you cannot hide your loss of licence. A third-party agency exists exactly to confirm, for people like me, whether you have one or not. But we can imagine other such “oblique obligations” for which there is no third-party verifying agent, at least not one prepared to tell you what you want to know.

Your own cashflow or balancesheet solvency, for example, or the amount of private indebtedness you have to third parties. These are, known only to your counterparty and others to whom the information is inherently confidential. They will not share it with you.

Now you can ask your customer to covenant or warrant that it is, and remains, solvent and that it debt load will not exceed a certain threshold.

But this is a tree in a distant forest. You cannot hear it. No-one else is talking. You rely upon your counterparty to pass this information to you, on pain of its failure to do so being itself an event of default.

Remember Bishop Berkeley. The actual information, that your customer has exceeded an arbitrary level of indebtedness that your credit department set for its own inscrutable reasons, matters, presumably, to your credit department, but not, in the particular, to your counterparty. It finds no call to articulate that fact. As far as the counterparty is concerned, no good can come of it.

Game theory comes into play here. If there are two evils, breaching a covenant and not owning up to it, the latter is the lesser. If they don’t know about the sheep, why let yourself be hung for a lamb?