1. 11 George Mason School of Law Contracts I Unconscionability F.H. Buckley fbuckley@gmu.edu

2. Next day  Offers and Invitations to Treat  Acceptance  Counter-offers 2

3. 3 Forms of Unconsionability  UCC § 2-302. Unconscionable Contract or Clause  (1) If the court as a matter of law finds the contract or any clause of the contract to have been unconscionable at the time it was made the court may refuse to enforce the contract, or it may enforce the remainder of the contract without the unconscionable clause, or it may so limit the application of any unconscionable clause as to avoid any unconscionable result.

4. 4 Forms of Unconsionability  Substantive Unconscionability The “just price” doctrine  Procedural Unconscionability “bargaining naughtiness”

5. 5 Substantive Unconscionability  Thornborrow v. Whitacre, 92 Eng.Rep. 270 (1705): W. borrows £5 and in return promises to pay two grains of rye-corn in the first week, four in the second, eight in the third, and so on for a year. The court refused to enforce the contract when it appeared that there was not enough grain in the whole world to satisfy this.

6. 6 Substantive Unconscionability in Walker-Thomas Furniture? 6 Consumer lending and usury

7. 7 Substantive Unconscionability  Why did the church prohibit usury?

8. 8 Substantive Unconscionability  Why did the church prohibit usury? The Biblical prohibition against taking interest on a loan Deut. 23:20Unto a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury: that the LORD thy God may bless thee …. Canon 27, Council of Nicea

9. 9 Substantive Unconscionability  Why did the church prohibit usury? The Biblical prohibition? Rent-seeking?  Tolleson et al., 5 J.L.E.O. 307 (1989)

10. 10 Substantive Unconscionability  Why did the church prohibit usury? The Biblical prohibition? Rent-seeking Moral Hazard?: Eric Posner

11. 11 Moral Hazard A range of outcomes associated with an investment opportunity

12. 12 Moral Hazard How is one’s economic calculus affected if costs are curtailed at 0 on the left side of the curve?

13. 13 Moral Hazard In that case, it’s all upside

14. 14 Moral Hazard I wouldn’t do this without insurance!

15. 15 Moral Hazard Do traffic signals cause accidents?

16. 16 How to reduce speed levels…

17. 17 Substantive Unconscionability  Why would a consumer agree to high interest rates?

18. 18 Substantive Unconscionability  Why would a consumer agree to high interest rates? Ignorance as to the terms?

19. 19 Substantive Unconscionability  Why would a consumer agree to high interest rates? Ignorance as to the terms? Signalling?  Two borrowers approach a lender. One is high risk, the other low risk. The borrowers know their quality but the lender cannot tell them apart. How can he distinguish them?

20. 20 Substantive Unconscionability  Signalling?  Two borrowers approach a lender. One is high risk, the other low risk. The borrowers know their quality but the lender cannot tell them apart. How can he distinguish them?  Assume that the low risk borrower can hold his hand in a fire for a longer period of time…

21. 21 Substantive Unconscionability  Signalling?  Two borrowers approach a lender. One is high risk, the other low risk. The borrowers know their quality but the lender cannot tell them apart. How can he distinguish them?  The willingness to do so might provide a separating equilibrium

22. 22 Substantive Unconscionability  Signalling: Separating and pooling equilibria:

23. 23 Secured Lending as a separating equilibrium  Signalling?  Two borrowers approach a lender. One is high risk, the other low risk. The borrowers know their quality but the lender cannot tell them apart. How can he distinguish them?  Assume that default is costly for both borrowers. However, the low risk borrower has a lower probability of default and a lower cost of default

24. 24 Substantive Unconscionability  Separating and pooling equilibria:  Separating equilibrium: Benefit > Cost High Quality Borrower Benefit < Cost Low Quality Borrower

25. 25 Substantive Unconscionability  Separating and pooling equilibria:  Separating equilibrium: Benefit > Cost High Quality Borrower Benefit < Cost Low Quality Borrower  Pooling equilibrium: Benefit > Cost High Quality Borrower Benefit > Cost Low Quality Borrower

26. 26 Cheap Talk as a Pooling Equilibrium Hobbes: He which performeth first doth but betray himself to his enemy.

27. 27 Substantive Unconscionability  Signalling?  Two borrowers approach a lender. One is high risk, the other low risk. The borrowers know their quality but the lender cannot tell them apart. How can he distinguish them?  A separating equilibrium if the low risk borrower is ready to accept a penalty on default?

28. 28 Now Procedural Unconscionability

29. 29 Now Procedural Unconscionability  Is unconscionability something different from the fraudlets we have seen? Is it simply all or many of them, in the ensemble? Or a weaker threshold for the Π? Or something else entirely?

30. 30 Now Procedural Unconscionability  Just what was wrong in Walker- Thomas?

31. 31 Now Procedural Unconscionability  Just what was wrong in Walker- Thomas? Capacity Poverty Nature of goods Welfare grants Kids

32. 32 Seabrook: 502 Apartment to be ready three months later 32 Unfinished Apartment Building

33. 33 Seabrook  Let’s say your counsel for Commuter Housing. How would you draft clauses 33 and 19 differently? 33

34. 34 Seabrook  Can you articulate the legal principle behind the case? 34

35. 35 Here’s one… 35

36. 36 Seabrook  Did the lessee have “no choice but to sign an unconscionable lease agreement” “does not have the option of shopping around” 36

37. 37 Seabrook  Did the lessee have “no choice but to sign an unconscionable lease agreement” Were there other rental properties in NYC? 37

38. 38 Seabrook  Did the lessee have “no choice but to sign an unconscionable lease agreement” Were there other rental properties in NYC? If they were hard to get, might rent control have had something to do with this? 38

39. 39 Seabrook  Just what was unconscionable? Did the lessee know that the building was not completed when he signed the lease? 39

40. 40 Seabrook  Just what was unconscionable? Do you think the lessee might have considered that there was a possibility that the building would not be completed three months later? 40

41. 41 Seabrook  Just what was unconscionable? Do you think the lessee might have considered that there was a possibility that the building would not be completed three months later? What do you think he would have expected to happen in that case? 41

42. 42 Seabrook  Just what was unconscionable? Do you think the lessee might have considered that there was a possibility that the building would not be completed three months later? What do you think he would have expected to happen in that case? What do you think was the Δ’s argument? 42

43. 43 Seabrook  If you’ve rented an apartment, did you sign a lease agreement? Can you articulate the principle that such agreements are unenforceable “in our enlightened society”? What do you think the consequences might be if lease contracts are presumptively unenforceable? 43

44. 44 Seabrook  If you’re advising a lessor, do you take any drafting tips from this case? 44

45. 45 Seabrook  If you’re advising a lessor, do you take any drafting tips from this case? If you thought that the lessor should have known just what problem would arise, is that the hindsight bias at work? 45

46. 46 Henningsen 1960 Plymouth 46

47. 47 Henningsen 1960 Plymouth … in two-tone! 47

48. 48 Henningsen With a push-button tranmission! 48

49. 49 And today? 2011 Chevrolet Spark

50. 50 Henningsen 1960 Plymouth 50

51. 51 Henningsen And what did they do with their car!! 51

52. 52 Henningsen  What did the warranty cover? Can you think of any business reason why it was drafted that way? 52

53. 53 Henningsen  Was the exemption clause per se illegal (substantive unconscionability)? “Inimical to the public good” 53

54. 54 Henningsen  Was the exemption clause per se illegal? “Inimical to the public good”  But also “grossly disproportionate bargaining power” 54

55. 55 Henningsen 55 Friedrich Kessler

56. 56 Henningsen  Were the Big Three immune from competition? 56

57. 57 Henningsen  Were the Big Three immune from competition?  Is a similarity in prices or terms across a market evidence of cartelization? 57

58. 58 Henningsen  Were the Big Three immune from competition?  Is a similarity in prices or terms across a market evidence of cartelization?  Would you expect to see more competition as to prices than as to terms? 58

59. 59 Henningsen  Were the Big Three immune from competition?  Is a similarity in prices or terms across a market evidence of cartelization?  Does competition as to terms assume that all consumers screen? Free riding? 59

60. 60 Henningsen  Were the Big Three immune from competition?  Is a similarity in prices or terms across a market evidence of cartelization?  Does competition as to terms assume that all consumers screen? Suppose you heard that one firm had an extortionate contract? 60

61. 61

62. 62 Substantive Unconscionability again The two-person bargaining game  The Edgeworth Box Function provided a bargaining model based on ordinal utility (indifference curves) 62

63. 63 The two-person bargaining game  The Edgeworth Box Function teaches us that bargaining is a non-zero sum game  But at the heart of the bargaining game is a zero-sum game 63

64. 64 Mary Bess A   B C D E  F  G    Recall the Contract Curve Indifference curve in commodity space

65. 65 A B C F G A is the endowment point Blowing up the bargaining lens

66. 66 Mary Bess A   B C D E  F  G    Recall the Contract Curve Indifference curve in commodity space

67. 67 A B C F G At C Mary is much better off than at A, and Bess is neither better nor worse off A is the endowment point Blowing up the bargaining lens

68. 68 A B C F G At B Bess is much better off than at A, and Mary is neither better nor worse off A is the endowment point Blowing up the bargaining lens

69. 69 A B C F G A is the endowment point At G both parties are better off than at A Blowing up the bargaining lens

70. 70 A B C F G Does unconscionability have anything to do with how bargaining gains are divided? Is your intuition that G is in some sense fairer than B or C?

71. 71 A B C F G Does unconscionability have anything to do with how bargaining gains are divided? But as we are talking about ordinal utility, it is not meaningful to speak of how much better off someone is at G relative to B or C

72. 72 A B C F G Does unconscionability have anything to do with how bargaining gains are divided? To do so, we would need to move from ordinal to cardinal utility

73. 73 Ordinal and Cardinal Utility  Ordinal numbers: First, second, third…  Cardinal numbers: 1, 2, 3 … 73

74. 74 Ordinal and Cardinal Utility  The Edgeworth Box Function provided a bargaining model based on ordinal utility (indifference curves)  However, prior to the ordinalist revolution of the 1930s, economists thought of utility in a cardinal way 74

75. 75 Cardinal utility 75 Act always to increase the greatest happiness of the greatest number The “auto-icon”

76. 76 The Ordinalist Revolution  One could dispense with cardinal utility and interpersonal comparisons while preserving much of standard economics by concentrating on choices made at the margin 76 Vilfredo Pareto

77. 77 The Revival of Cardinal Utility Game Theory 77 John von Neuman, Theory of Games and Economic Behavior (1944)

78. 78 Are you a cardinalist?  Not if you think interpersonal utility comparisons aren’t meaningful 78

79. 79 Are you a cardinalist?  You are charged with designing a country’s welfare policy. Should wealth transfers be from rich to poor or the other way around? 79

80. 80 Are you a cardinalist?  You are charged with designing a country’s welfare policy. Should wealth transfers be from rich to poor or the other way around? 80 Blimey, this social justice business is trickier than I thought!

81. 81 AG C We move from commodity to utility space Cardinalists assume we can measure utility levels

82. 82 AG C The units of measurement are now in “utils,” not commodities Cardinalists assume we can measure utility levels

83. 83 AG C Cardinal, not ordinal utility Utility space Let’s suppose we can measure Mary’s utility levels

84. 84 AG C G'G' B Mary’s utility Bess’s utility Utility Space And suppose we can do the same for Bess

85. 85 0 1.0 Mary Bess To simplify we normalize the utility functions of both from 0 to 1.0

86. 86 AC B BC is concave (bends outward) because we assume that joint utility is maximized when gains are shared Mary Bess We can then represent the contract curve in utility space

87. 87 AC B Mary Bess The Presolution BC represents the “presolution” to the game: it is feasible and efficient

88. 88 Mary Bess A   B C D E  F  G    Recall where we’re getting this from

89. 89 0 1.0 Mary Bess The “solution” to the two-person bargaining game picks one point on the contract curve The Solution

90. 90 0 1.0 Mary Bess Nash solution of (.75*.8 =).6 Howard Raiffa, The Art and Science of Negotiation (1982) Nash maximizes the product of the utility gains The Nash Solution

91. 91 0 1.0 Mary Bess Mary insists on a payoff of.95.95.95.95 The hard bargainer doesn’t seek the Nash Solution

92. 92  We have $1,000 to divide between us.  I first decide how the money is to divided. The ultimatum game

93. 93  We have $1,000 to divide between us.  I first decide how the money is to divided.  In the second stage you decide whether or not to accept the split I propose. The ultimatum game

94. 94  We have $1,000 to divide between us.  I first decide how the money is to divided.  In the second stage you decide whether or not to accept the split I propose.  If you accept the split we both take our respective shares.  If you reject the split neither of us get anything. The ultimatum game

95. 95  In the first round I choose $950, leaving you $50  Take it or leave it? The ultimatum game

96. 96 The ultimatum game Player 1 FairUnfair Accept Reject 500, 5000, 0 950, 50 Player 2 Is the unfair solution Paretian?

97. 97  You see that Safeway refuses to charge a premium for a shovel during a snow storm Is it being irrational? Do we have built-in fairness constraints?

98. 98  Do men play differently than women? Do we have built-in fairness constraints?

99. 99  Do people play differently when the payoffs are higher? Do we have built-in fairness constraints?

100. 100  Do people play differently when they are told that player 1 has “earned” the money? Do we have built-in fairness constraints?

101. 101 0 1.0 Mary Bess Qu. How many such bargains will be lost through bargaining breakdown?.95 The hard bargainer

102. 102 0 1.0 Mary Bess Assume that an arbitrator can measure utilities and refuses to enforce bargains that allocate.95 of the gains to one party.95 Getting to Yes: Suppose we resist enforcing hard bargains?

103. 103 0 1.0 Mary Bess Some contracts will not be enforced. But might more be entered into because hard bargainers have been chilled?.95 Getting to Yes: Suppose we resist enforcing hard bargains?

104. 104  Suppose we refused to enforce bargains that appear wholly one- sided? This would result in an efficiency loss. But would chilling the hard bargainers result in a greater number or bargains, and a net efficiency gain? Now back to the ultimatum game

105. Last fairness question: Distributional Justice 105

106. 106 Mary Bess A   B C D E  F  G    Distributional Justice: Who says it was fair to start at point A?

107. 107 Mary Bess A   B C D E  F  G    Distributional Justice: What if we started at point E?

108. 108 George Mason School of Law Contracts II F.H. Buckley fbuckley@gmu.edu