Econ 522Economics of Law

Dan Quint

Fall 2010

Lecture 13

2

Example of reliance, and why we might get overreliance

Regulations, derogation of public policy

Formation defenses and performance excuses Incompetence (but not drunkenness) Duress and necessity

Today: more ways to get out of a contract

Last Wednesday…

3

Court won’t enforce contracts signed under threat of harm “Give me $100 or I’ll shoot you”

But many negotiations contain threats “Give me a raise, or I’ll quit” “$3,000 is my final offer for the car, take it or I walk”

The difference? Threat of destruction of value versus failure to create value A promise is enforceable if extracted as price of cooperating in

creating value; not if it was extracted by threat to destroy value

Real duress versus fake duress

4

Captain hires crew in Seattle for fishing expedition to Alaska

In Alaska, crew demands higher wages or they’ll quit

Captain agrees

Back in Seattle, refuses higher wages, claiming duress

Example: Alaska Packers’ Association v Domenico (US Ct App 1902)

5

A performance excuse:impossibility

6

When performance becomes impossible, should promisor owe damages, or be excused from performing?

A perfect contract would explicitly state who bears each risk

Contract may give clues as to how gaps should be filled

Industry custom might be clear

But in some cases, court must fill gap

Next doctrine for voiding a contract: impossibility

7

In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach

But there are exceptions Change “destroyed a basic assumption on which the contract was

made”

Next doctrine for voiding a contract: impossibility

8

In most situations, when neither contract nor industry norm offers guidance, promisor is held liable for breach

But there are exceptions Change “destroyed a basic assumption on which the contract was

made”

Efficiency requires assigning liability to the party that can bear the risk at least cost Party that can take precautions to minimize the risk Or can best spread the risk over many transactions

Next doctrine for voiding a contract: impossibility

9

Who is the efficient bearer of a particular risk? Also called low-cost avoider Who is in best position to mitigate/reduce a risk, or hedge it, or endure

it?

We already saw this question with efficient default rules When a contract leaves a gap, an efficient contract would have

allocated each risk to low-cost avoider Construction company building a house, completion is delayed

Family might be efficient risk-bearer, because it’s cheaper for them to stay with friends than for construction company to pay for hotel

Cost of raw materials goes up, increasing cost of construction Construction company might be efficient risk-bearer, because they can buy

materials early or change design plans

Important general concept

10

When performance becomes impossible, assign liability to party who can bear risk at least cost

How do we know who this is? Friedman offers several bases for this decision… Spreading losses across many transactions Moral hazard: who is in better position to influence outcome?

Who is the efficient bearer of a particular risk?

11

When performance becomes impossible, assign liability to party who can bear risk at least cost

How do we know who this is? Friedman offers several bases for this decision… Spreading losses across many transactions Moral hazard: who is in better position to influence outcome? Adverse selection: who is more aware of risk, even if he can’t do anything

about it? “…The party with control over some part of the production process is in a

better position both to prevent losses and to predict them.

It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”

Who is the efficient bearer of a particular risk?

12

Suppose… 80% of millers are low-damage – suffer $100 in losses from delay 20% of millers are high-damage – suffer $200 in losses from delay

Shipper liable for actual damages Average miller would suffer $120 in losses Shipper makes efficient investment for average type But not efficient for either type

Shipper liable for foreseeable damages Shipper makes efficient investment for low-damage millers High-damage millers have strong incentive to negotiate around default

rule

Hadley v Baxendale

13

Contracts based onbad information

14

Four doctrines for invalidating a contract based on faulty information Fraud Failure to disclose Frustration of purpose Mutual mistake

Misinformation

15

Fraud violates “negative duty” not to misinform

In some circumstances, positive duty to disclose certain information Civil law: contract may be voided if you did not supply information

you should have (“failure to disclose”) Common law: seller is not forced to disclose everything he knows

Must warn about hidden dangers Need not share information that makes product less valuable but not

dangerous But, new products come with “implied warranty of fitness”

Fraud and Failure to Disclose

16

Both parties based a contract on the same bad information contract may be voided due to frustration of purpose

Coronation Cases Rooms rented out with view of new king’s coronation parade Parade was postponed, owners still tried to collect rent Courts ruled change in circumstance had frustrated the purpose of

the original contracts, which were therefore void

“When a contingency makes performance pointless, assign liability to the party who can bear the risk at least cost”

Frustration of Purpose

17

Frustration of purpose: circumstances changed after the contract was signed

Mutual mistake: circumstances changed before the contract was signed, but the parties didn’t know about it

Enforcing the contract would be like forcing involuntary exchange Coase: we expect voluntary exchange to be efficient But involuntary exchange may not be

Mutual Mistake

18

Hadley v Baxendale (miller and shipper) Hadley knew shipment was time-critical But Baxendale was deciding how to ship crankshaft (boat or train)

A general principle about information: efficiency generally requires uniting knowledge and control Contracts that unite knowledge and control are generally efficient,

should be upheld Contracts that separate knowledge and control may be inefficient,

should more often be set aside

Another principle: knowledge and control

19

Mutual mistake: neither party had correct information Contract neither united nor separated knowledge and control

Unilateral mistake: one party has mistaken information I know your car is a valuable antique, you think it’s worthless You sell it to me at a low price

Contracts based on unilateral mistake are generally upheld

Unilateral mistake

20

Mutual mistake: neither party had correct information Contract neither united nor separated knowledge and control

Unilateral mistake: one party has mistaken information I know your car is a valuable antique, you think it’s worthless You sell it to me at a low price

Contracts based on unilateral mistake are generally upheld Contracts based on unilateral mistake generally unite knowledge and

control And this creates an incentive to gather information

Unilateral mistake

21

War of 1812: British blockaded port of New Orleans Price of tobacco fell, since it couldn’t be exported

Organ (tobacco buyer) learned the war was over Immediately negotiated with Laidlaw firm to buy a bunch of tobacco

at the depressed wartime price

Next day, news broke the war had ended, price of tobacco went up, Laidlaw sued Supreme Court ruled that Organ was not required to communicate

his information

Unilateral mistake: Laidlaw v Organ (U.S. Supreme Court, 1815)

22

Productive information: information that can be used to produce more wealth

Redistributive information: information that can be used to redistribute wealth in favor of informed party

Cooter and Ulen Contracts based on one party’s knowledge of productive information –

especially if that knowledge was the result of active investment – should be enforced

Contracts based on one party’s knowledge of purely redistributive information or fortuitously acquired information should not be enforced

Unilateral mistake: productive versus redistributive information

23

Sellers must inform buyers about hidden safety risks

Common law does not generally require disclosure of other types of information

But… Obde v Schlemeyer (1960) Seller knew building was infested with termites, did not tell buyer Termites should have been exterminated immediately to prevent

further damage Court in Obde imposed duty to disclose Sale did not unite knowledge and control

More on duty to disclose

24

Sellers must inform buyers about hidden safety risks

Common law does not generally require disclosure of other types of information

But… Obde v Schlemeyer (1960) Seller knew building was infested with termites, did not tell buyer Termites should have been exterminated immediately to prevent further

damage Court in Obde imposed duty to disclose Sale did not unite knowledge and control Many states require used car dealers to reveal major repairs done,

sellers of homes to reveal certain types of defects…

More on duty to disclose

25

Other reasons a contract may not be enforced

26

Courts will generally not enforce contract terms that are overly vague

Can be thought of as a penalty default

But some exceptions Parties may commit to renegotiating the contract “in good faith”

under certain contingencies

Vague contract terms

27

Bargain theory: courts ask only whether a contract was part of a bargain, not whether that bargain was fair Hamer v Sidway (drinking and smoking)

But two common law doctrines to get out of extremely one-sided contracts Adhesion Unconscionability

Fairness

28

Adhesion: standardized “take-it-or-leave-it” contracts Friedman calls it “bogus duress”

One extreme version: “shrink-wrap licenses” “By opening the box, you have already agreed to…”

More general problem: people never read the fine print…

Contracts of adhesion

29

Adhesion?

Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/

30

British computer game retailer GameStation, on April Fool’s Day, added this to Terms & Conditions customers agreed to before buying online:

“By placing an order via this website… you agree to grant us a non transferable option to claim, for now and for ever more, your immortal soul.

Should we wish to exercise this option, you agree to surrender your immortal soul, and any claim you may have on it, within 5 (five) working days of receiving written notification from gamestation.co.uk or one of its duly authorised minions.

…If you a) do not believe you have an immortal soul, b) have already given it to another party, or c) do not wish to grant us such a license, please click the link below to nullify this sub-clause and proceed with your transaction.”

Adhesion?

31

Overly one-sided contract may not be enforced

Terms “such that no man in his senses and not under delusion would make on the one hand, and as no honest and fair man would accept on the other”

When “the sum total of its provisions drives too hard a bargain for a court of conscience to assist”

Terms which would “shock the conscience of the court”

Similar concept in civil law: lesion

Unconscionability

32

“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.

…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)

33

“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.

…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)

34

“Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.

…In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

Not normal monopoly cases but “situational monopolies” Think of Ploof v Putnam (sailboat in a storm), not Microsoft

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965)

35

Remedies for breachof contract

36

Party-designed remedies Remedies specified in the contract

Court-imposed damages Court may decide promisee entitled to some level of damages

Specific performance Forces breaching party to live up to contract

Three broad types of remedy for breach of contract

37

Compensate promisee for the amount he expected to benefit from performance You agreed to buy an airplane for $350,000 You expected $500,000 of benefit from it Expectation damages: if I breach, I owe you that benefit ($500,000 if you already paid, $150,000 if you didn’t)

“Positive damages”

Make promisee indifferent between performance and breach

Expectation damages

38

Reimburse promisee for cost of any reliance investments made, but not for additional surplus he expected to gain

Restore promisee to level of well-being before he signed the contract You contracted to buy the plane and built a hangar If I breach, I owe you what you spent on the hangar, nothing else

“Negative damages” – undo the negative (harm) that occurred

Reliance damages

39

Give promisee benefit he would have gotten from his next-best option Make promisee indifferent between breach of the contract that

was signed, and performance of best alternative contract You value plane at $500,000 You contract to buy plane from me for $350,000 Someone else was selling similar plane for $400,000 By the time I breach, that plane is no longer available I owe you $100,000 – the benefit you would have gotten from

buying the other seller’s plane

Opportunity cost damages

40

You agree to sell me ticket to Wisconsin-Michigan football game for $50 Expectation damages: you owe me value of game minus $50 If I pay scalper $150, then expectation damages = $100 Reliance damages: maybe 0, or cost of face paint and giant foam

finger

Example: expectation, reliance, and opportunity cost damages

41

You agree to sell me ticket to Wisconsin-Michigan football game for $50 Expectation damages: you owe me value of game minus $50 If I pay scalper $150, then expectation damages = $100 Reliance damages: maybe 0, or cost of face paint and giant foam

finger When you agreed to sell me ticket, other tickets available for $70 Opportunity cost damages: $80 (I paid a scalper $150 to get in; I would have been $80 better off if

I’d ignored your offer and paid someone else $70)

Example: expectation, reliance, and opportunity cost damages

42

Ranking damages

ExpectationDamages

Opportunity CostDamages

RelianceDamages

ContractI Sign

BestAlternative

Do Nothing

Breach +ExpectationDamages

Breach +Opportunity Cost

Damages

Breach +RelianceDamages

$100 $80 $0-20

43

Hawkins had a scar on his hand

McGee promised surgery to “make the hand a hundred percent perfect”

Surgery was a disaster, left scar bigger and covered with hair

Hawkins v McGee (“hairy hand case”)

44

Hawkins v McGee (“hairy hand case”)

Hairy Scarred Nextbest

doctor

100%Perfect

$

Hand

Initial Wealth

+ Reliance Damages

+ Opp Cost Damages

+ Expectation Damages

Rel

ianc

e D

amag

es

Opp

Cos

t Dam

ages

Exp

ecta

tion

Dam

ages

45

Expectation damages Give promisee benefit he would have had from performance

Opportunity cost damages Give promisee benefit he would have had from next-best contract

Reliance damages Give promisee benefit he would have had from doing nothing

Expectation Dam Opp Cost Dam Reliance Dam But order can be reversed when calculated incorrectly

Recapping different types of damages

46

Restitution Return money that was already received

Disgorgement Give up wrongfully-gained profits

Other court-ordered remedies

47

Restitution Return money that was already received

Disgorgement Give up wrongfully-gained profits

Specific Performance Promisor is forced to honor promise Civil law: often ordered instead of money damages Common law: money damages more common; S.P. sometimes used

when seller breaches contract to sell a unique good Like injunctive relief

Other court-ordered remedies

48

Restitution Return money that was already received

Disgorgement Give up wrongfully-gained profits

Specific Performance Promisor is forced to honor promise Civil law: often ordered instead of money damages Common law: money damages more common; S.P. sometimes used

when seller breaches contract to sell a unique good Like injunctive relief

Other court-ordered remedies

49

Remedy for breach could be written directly into contract

But common law courts don’t always enforce remedy terms Liquidated damages – party-specified damages that reasonably

approximate actual harm done by breach Penalty damages – damages greater than actual harm done Civil law courts are generally willing to enforce penalty damages But common law courts often do not

Party-designed remedies

50

Peevyhouse v Garland Coal Peevyhouses only wanted farm strip-mined if it would be restored

to original condition after Suppose coal extracted worth $70,000 Garland paid $25,000 for rights to mine it Restoration work would cost $30,000 Diminution of value was $300 So liquidated damages would be $300 Suppose Peevyhouses got $40,000 of disutility from land being left

in poor condition

Penalty DamagesCoal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000

51

Liquidated damages

Peevyhouses

Sign Don’t

Garland Coal

Restore property Don’t, pay damages

(25,000, 15,000) (-14,700, 44,700)

(0, 0)

If damages limited to liquidated damages… Peevyhouses have no reason to believe restorative work will get done So Peevyhouses better off refusing to sign Even though mining and restoring Pareto-dominates

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000

52

Penalty damages

Peevyhouses

Sign Don’t

Garland Coal

Restore property Don’t, pay penalty

(25,000, 15,000) (25,000, 5,000)

(0, 0)

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000

If penalty clauses in contracts enforceable… Write contract with $40,000 penalty for leaving land unrestored Now restoration work would get done, so Peevyhouses willing to sign But if courts won’t enforce penalty damages, this won’t work

53

Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus I agree to pay $200,000 to get house built, but I want you to pay a

$50,000 penalty if it’s late Alternatively: I agree to pay $150,000 for house, plus a $50,000

performance bonus if it’s completed on time Either way, you get $150,000 if house is late, $200,000 if on time Courts generally enforce bonus clauses, so no problem!

Penalty clauses

54

Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus I agree to pay $200,000 to get house built, but I want you to pay a

$50,000 penalty if it’s late Alternatively: I agree to pay $150,000 for house, plus a $50,000

performance bonus if it’s completed on time Either way, you get $150,000 if house is late, $200,000 if on time Courts generally enforce bonus clauses, so no problem! Similarly, Peevyhouse example

Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is not restored

Equivalently, get $65,000 for mining rights, pay $40,000 bonus if restoration is completed

But, if intent of contract is too transparent, still might not be enforced

Penalty clauses