1. Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 13

2. 1  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. 2  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. 3  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. 4 A performance excuse: impossibility

6. 5  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. 6  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. 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”  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. 8  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. 9  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. 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?  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. 11  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. 12 Contracts based on bad information

14. 13  Four doctrines for invalidating a contract based on faulty information  Fraud  Failure to disclose  Frustration of purpose  Mutual mistake Misinformation

15. 14  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. 15  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. 16  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. 17  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. 18  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. 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  Contracts based on unilateral mistake generally unite knowledge and control  And this creates an incentive to gather information Unilateral mistake

21. 20  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. 21  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. 22  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. 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  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. 24 Other reasons a contract may not be enforced

26. 25  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. 26  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. 27  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. 28 Adhesion? Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/

30. 29  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. 30  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. 31  “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. 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)

34. 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.”  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. 34 Remedies for breach of contract

36. 35  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. 36  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. 37  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. 38  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. 39  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. 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  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. 41 Ranking damages Expectation Damages Opportunity Cost Damages Reliance Damages  Contract I Sign Best Alternative Do Nothing  Breach + Expectation Damages Breach + Opportunity Cost Damages Breach + Reliance Damages  $100$80$0-20 

43. 42  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. 43 Hawkins v McGee (“hairy hand case”) HairyScarredNext best doctor 100% Perfect $ Hand Initial Wealth + Reliance Damages + Opp Cost Damages + Expectation Damages Reliance DamagesOpp Cost DamagesExpectation Damages

45. 44  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. 45  Restitution  Return money that was already received  Disgorgement  Give up wrongfully-gained profits Other court-ordered remedies

47. 46  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. 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

49. 48  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. 49  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 Damages Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000

51. 50 Liquidated damages Peevyhouses SignDon’t Garland Coal Restore propertyDon’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 $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses value restoration at $40,000

52. 51 Penalty damages Peevyhouses SignDon’t Garland Coal Restore propertyDon’t, pay penalty (25,000, 15,000)(25,000, 5,000) (0, 0) Coal worth $70,000 Garland to pay $25,000 Restoration would cost $30,000 Liquidated damages are $300 Peevyhouses 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. 52  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. 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!  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