Econ 522Economics of Law

Dan QuintFall 2013Lecture 13

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MT1 next Wednesday in Education L196

Logistics

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Breach of contract

Reliance

How liability for breach creates incentive for both, paradox of compensation

Default rules C&U: impute the rule the parties would have wanted and apply that That’s whatever rule would have been efficient – allocating each risk to

whoever can bear it most cheaply

So far in contract law…

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Old urban legend:A man bought a box of extremely rare and expensive cigars, and insured them against loss or damage.After smoking them, he filed an insurance claim, saying they had been destroyed in 20 separate small fires.The insurance company refused to pay, the man sued and won.But as he was leaving the courtroom, he was arrested on 20 counts of arson.

Serious question:If the intent of a contract is clear, but different from the literal meaning, which should be enforced?

Discussion question

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Back toDefault Rules

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Default rules – rules that apply in circumstances not addressed in the contract

Cooter and Ulen: impute rule most parties would have wanted, which is efficient rule, and apply that

Ayres and Gertner: not necessarily

From Monday

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Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules”

Sometimes better to make default rule something the parties would not have wanted To give incentive to address an issue rather than leave a gap Or to give one party incentive to disclose information “Penalty default”

Default rules: a different view

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Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk

If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent

So Hadley might hide this information, which is inefficient Ayres and Gertner: Ruling in Hadley was a good one, not because

it was efficient, but because it was inefficient… …but in a way that created incentive for disclosing information

Penalty defaults: Hadley v Baxendale

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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

Penalty defaults: example

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Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to

bring it up if it’s efficient to change this

Penalty defaults: other examples

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Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to

bring it up if it’s efficient to change this

Courts will impute missing price of a good, but not quantity Forces parties to explicitly contract on quantity, rather than leave it

for court to decide

Penalty defaults: other examples

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Look at why the parties left a gap in contract Because of transaction costs use efficient rule For strategic reasons penalty default may be more efficient

Similar logic in a Supreme Court dissent by Justice Scalia Congress passed a RICO law without statute of limitations Majority decided on 4 years – what they thought legislature would have

chosen Scalia proposed no statute of limitations; “unmoved by the fear that this…

might prove repugnant to the genius of our law…” “Indeed, it might even prompt Congress to enact a limitations period that it

believes appropriate, a judgment far more within its competence than ours.”

When to use penalty defaults?

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When should a contractnot be enforced?

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Going back to property law… Coase Theorem: to get efficient outcomes, we should let people trade

whenever they want to But also saw some exceptions – some trades that aren’t, and shouldn’t,

be allowed Selling enriched uranium to a terrorist

Similarly with contract law… First day: to get efficient outcomes, enforce any contract both parties

wanted enforced But next, we’ll see exceptions – contracts which shouldn’t be enforced,

due to externalities or market failures/transaction costs

When should voluntary trade not be allowed?

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Obvious: contract to buy a kilo of cocaine is unenforceable

Example of an unenforceable contract: a contract which breaks the law

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Obvious: contract to buy a kilo of cocaine is unenforceable

Less obvious: otherwise-legal contract whose real purpose is to circumvent a law Legal doctrine: derogation of public policy Derogate, verb. detract from; curtail application of (a law) Applies to contracts which could only be performed by breaking

law… …but also to “innocent” contracts whose purpose is to get around a

law or regulation

Example of an unenforceable contract: a contract which breaks the law

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Labor unions required by law to negotiate “in good faith”

Recent NBA labor troubles Old CBA: 57% of “basketball-related income” went to player salaries Owners were offering less than 50%, players demanding 53%... Imagine the following contract:

“For the next 50 years, if the NBAPAaccepts a CBA paying less than 55%of BRI in player salaries, then we alsoagree that all non-retired players will work for you as coal miners everyoffseason at federal minimum wage.”

Purpose is purely to “bind hands” innegotiations with ownership

Contract would not be enforced

Derogation of public policy – example

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In general: a contract is not enforceable if it cannot be performed without breaking the law

Exception: if promisor knew (and promisee didn’t) I’m married, my girlfriend in California doesn’t know; I promise her I’ll

marry her, she quits her job and moves to Madison My company agrees to supply a product that we can’t produce without

violating a safety or environmental regulation Keeping either promise would require breaking the law… …but I’d still be liable for damages for breach

Like in Ayres and Gertner: default rule penalizes better-informed party for withholding information

Derogation of public policy

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Talked earlier about default rules Default rules apply if no other rule is specified… …but can be contracted around

Rules like “derogation of public policy” cannot be contracted around Parties to a contract can’t say, “even though this type of contract would

normally not be valid, this one is” Rules which always apply: immutable rules, or mandatory rules, or

regulations

Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations.

Default rules versus regulations

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Ways to get outof a contract

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Formation defense Claim that a valid contract does not exist (Example: no consideration)

Performance excuse Yes, a valid contract was created But circumstances have changed and I should be allowed to not perform

without penalty

Most doctrines for invalidating a contract can be explained as either… Individuals agreeing to the contract were not rational, or Transaction cost or market failure

Formation Defenses and Performance Excuses

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Courts will not enforce contracts with peoplewho can’t be presumed to be rational Children Legally insane

Incompetence One party was “not

competent to enter intothe agreement”

No “meeting of the minds”

One formation defense: incompetence

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If courts won’t enforce a contract signed by someone who wasn’t competent…

What if you signed a contract while drunk? You need to have been really, really, really drunk to get out of a

contract (“Intoxicated to the extent of being unable to comprehend the

nature and consequences of the instrument he executed”) Lucy v. Zehmer, Virginia Sup Ct 1954

So…

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Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time

While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”

“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”

Lucy v. Zehmer

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Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time

While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”

“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”

Lucy v. Zehmer

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So, you can be pretty drunk and still be bound by the contract you signed Might think “meeting of the minds” would be impossible But imagine what would happen if the rule went the other way

Lucy v. Zehmer

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So, you can be pretty drunk and still be bound by the contract you signed Might think “meeting of the minds” would be impossible But imagine what would happen if the rule went the other way

Borat lawsuits Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk

Journalist for Make Benefit Guileless Americans In Film”

Moral of the story: don’t get drunk with people who might ask you to sign a contract

Lucy v. Zehmer

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Another formation defense:dire constraints

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Necessity I’m about to starve, someone offers me a sandwich for $10,000 My boat’s about to sink, someone offers me a ride to shore for

$1,000,000 Contract would not be upheld: I signed it out of necessity

Duress Other party is responsible for situation I’m in “I made him an offer he couldn’t refuse” Contract signed at gunpoint would not be

legally enforceable

Dire constraints

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source: http://news.yahoo.com/man-sues-former-hostages-says-broke-promise-190902970.html

Duress

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Example Mugger threatens to kill you unless you give him $100 You write him a check Do you have to honor the agreement?

“Efficiency requires enforcing a contract if both parties wanted it to be enforceable” He did – he wants your $100 You did – you’d rather pay $100 than be killed

So why not enforce it? Makes muggings more profitable leads to more muggings Tradeoff: refuse to enforce a Pareto-improving trade, in order to avoid

incentive for bad behavior

Friedman on duress

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Example Mugger threatens to kill you unless you give him $100 You write him a check Do you have to honor the agreement?

“Efficiency requires enforcing a contract if both parties wanted it to be enforceable” He did – he wants your $100 You did – you’d rather pay $100 than be killed

So why not enforce it? Makes muggings more profitable leads to more muggings Tradeoff: refuse to enforce a Pareto-improving trade, in order to avoid

incentive for bad behavior

Friedman on duress

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Same logic doesn’t work for necessity You get caught in a storm on your $1,000,000 sailboat Tugboat offers to tow you to shore for $900,000 (Otherwise he’ll save your life but let your boat sink)

Duress: if we enforce contract, incentive for more crimes

Necessity: if we enforce contract, incentive for more tugboats to be available to rescue sailboats Why is that bad?

What about necessity?

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What about necessity?

“Should I motor around looking for sailboats to save?” Social cost = private cost = value of my time Social benefit = probability x (value of boat – cost of tow) Private benefit = probability x (price I can charge – cost of tow) If tugboat captain can charge the whole value of the boat,

he spends efficient amount of time saving sailboats! So maybe we should enforce this contract…

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What about necessity?

“Should I sail today?” Suppose tugboat is there to rescue me if there’s a storm Social benefit = private benefit = how much I enjoy sailing Social cost = probability x cost of tow Private cost = probability x price he can charge If tugboat captain can only charge cost of tow, I sail efficient amount If he can charge the whole value of the boat, I undersail!

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Same transaction sets incentives on both parties Price that would be efficient for one decision, is inefficient for other

“Put the incentive where it would do the most good” Least inefficient price is somewhere in the middle And probably not the price that would be negotiated in the middle of

a storm!

Friedman’s point

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Same transaction sets incentives on both parties Price that would be efficient for one decision, is inefficient for other

“Put the incentive where it would do the most good” Least inefficient price is somewhere in the middle And probably not the price that would be negotiated in the middle of a

storm! So makes sense for courts to overturn contracts signed under necessity,

replace them with ex-ante optimal terms

More general point Single price creates multiple incentives May be impossible to get efficient behavior in all dimensions

Friedman’s point

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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

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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, captain refuses to pay the higher wages, claiming he agreed to them under duress

Court ruled for captain Since crew had already agreed to do the work, no new consideration was

given for promise of higher wage

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

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A performance excuse:impossibility

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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

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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

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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 How to determine who that is?

Next doctrine for voiding a contract: impossibility

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Friedman offers several bases for making this determination Spreading losses across many transactions Moral hazard: who is in better position to influence outcome?

Who is the efficient bearer of a particular risk?

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Friedman offers several bases for making this determination 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?

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Baxendale (shipper) could influence speed of delivery, Hadley could not

So Baxendale was efficient bearer of the risk of delay

Court ruled he didn’t owe damages for lost profits, forcing Hadley to bear much of this risk Only makes sense as a “penalty default” Rule creates incentive for Hadley to reveal urgency of this shipment

That’s why Hadley v Baxendale was “surprising”

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Contracts based onbad information

(won’t get to this)

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Four doctrines for invalidating a contract

Fraud

Failure to disclose

Frustration of purpose

Mutual mistake

Contracts based on faulty information

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Fraud: one party was deliberately tricked

Fraud

source: http://www.wyff4.com/r/29030818/detail.html

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Under the civil law, there is a duty to disclose If you fail to supply information you should have, contract will be

voided – failure to disclose

Less so under the common law Seller has to share information about hidden dangers… …but generally not information that makes a product less valuable

without making it dangerous Exception: new products come with “implied warranty of fitness” Another exception: Obde v Schlemeyer

What if you trick someone by withholding information?

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Under common law, seller required to inform buyer about hidden safety risks, generally not other information

But… Obde v Schlemeyer (1960, Sup Ct of WA) 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 (awarded damages)

Duty to disclose under common law

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Under common law, seller required to inform buyer about hidden safety risks, generally not other information

But… Obde v Schlemeyer (1960, Sup Ct of WA) 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 (awarded damages) Some states require used car dealers to reveal major repairs done,

sellers of homes to reveal certain types of defects…

Duty to disclose under common law

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Failure to disclose?

source: http://kdvr.com/2012/10/26/chinese-man-sues-wife-for-being-ugly-wins-120000/

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Frustration of Purpose

Change in circumstance made the original promise pointless

Coronation Cases

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

What if both parties were misinformed?

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Frustration of Purpose

Change in circumstance made the original promise pointless

Coronation Cases

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

What if both parties were misinformed?

Mutual Mistake

Mutual mistake about facts Circumstances had already

changed, but we didn’t know Logger buys land with timber

on it, but forest fire had wiped out the timber the week before

Mutual mistake about identity Disagreement over what was

being sold

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Hadley v Baxendale (miller and shipper) Hadley knew shipment was time-critical But Baxendale was deciding how to ship crankshaft (boat or train) Party that had information was not the party making decisions

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 for allocating risks efficiently: uniting knowledge and control

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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

Mutual vs. Unilateral Mistake

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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, enforcing them creates an incentive to gather information

Mutual vs. Unilateral Mistake

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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)

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Laidlaw v. Organ established: contracts based on unilateral mistake are generally valid Agrees with efficiency: these contracts typically unite knowledge

and control

What about Obde v. Schlemeyer? The termites case was based on unilateral mistake Court still upheld contract, but punished seller for hiding information In that case, contract separated knowledge from control

Uniting knowledge and control

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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

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