Econ 522 – Lecture 11 (Oct 14 2008)
HW 1 graded, will be returned at end of lecture, with solutions
HW 2 due a week from Thursday
Last Tuesday, we went further in examining efficient breach and efficient reliance, and
the type of damages that would lead to them. We found:
 It’s efficient to breach whenever the cost of performance exceeds the value of
performance
 And expectation damages lead to breach only when it’s efficient
 Reliance is efficient if its expected benefit (its benefit times the probability of
performance) exceeds its cost
 Adjusting expectation damages to include only efficient reliance creates the
correct incentive, but is difficult from a practical point of view
 The law tends to only reward foreseeable reliance, which is reliance that could
reasonably be expected given the situation
And we introduced the notion of default rules, which are rules that apply in
contingencies that weren’t explicitly addressed in a contract; and saw two very different
views of what default rules should be.
 Cooter and Ulen supported efficient default rules – that is, the rules that most
parties would have chosen if they had addressed a particular risk – so that most
parties can save transaction costs by not bothering to address those risks most of
the time
 Ayres and Gertner introduced the idea of penalty defaults – default rules that are
not efficient, but which penalize one party, in order to encourage them to disclose
information while negotiating the contract
 As an example, Hadley v Baxendale
At the end, we introduced the idea of immutable rules, or regulations, which are rules
that always apply, unlike default rules, which can be overruled by specific terms of a
contract.
Going back to Coase, if individuals are rational and there are no transaction costs, private
negotiations (in this case, contracting) will lead to efficiency, so any additional regulation
(any rules they’re not allowed to contract around) would be inefficient. Conversely,
regulation could be efficient in situations where individuals are not rational, or where
there are transaction costs, externalities, or market failures.
There’s not that much interesting to say about regulations, but we’ll begin with one
example: contracts which derogate public policy, that is, contracts whose effect is
contrary to government policy.
In the U.S., labor unions have a statutory obligation to bargain with management “in
good faith”. A contract between a labor union and a third party, which would violate this
obligation, would therefore derogate public policy, and not be enforced. An example of
this is a contract that “ties the union’s hands” in negotiations.
Suppose that the union (B) and ownership (C) at a factory are bargaining over wages.
The union wants its workers to earn $15 an hour, ownership is offering $10 an hour, and
negotiations are ongoing.
Now the union goes to a competing factory owner (A) and signs the following contract:
“If I ever sign a contract to work for C for less than $15 an hour, I promise to have all my
members work for you for $1 an hour.” The intent of the contract is not for it to actually
happen, just to change the union’s bargaining position with C, by “burning its bridges,”
that is, making it much more costly to back down from its demands.
Since this would violate the union’s obligation to bargain in good faith, this contract
would not be enforced.
(The notion of burning your bridges comes from Sun Tzu’s The Art of War: “When your
army has crossed the border [into hostile territory], you should burn your boats and
bridges, in order to make it clear to everybody that you have no hankering after home.”
By taking away your option of retreating, you make it clear that you’re serious about
fighting.)
There are other examples of contracts which would derogate public policy.
 The book gives the example of a victim of a crime offering a policeman a reward
for solving the crime. The police’s job is to solve crimes; allowing rewards might
distort the focus toward crimes with rewards, away from more important crimes
without rewards.
 Another example would be a contract among competitors to act as a cartel, similar
to a monopoly. A contract that fixed prices, say, would derogate laws designed to
foster competition, and would therefore be unenforceable.
 A contract to buy illegal drugs would similarly be considered unenforceable.
In general, contracts which can only be performed by breaking the law are not
enforceable.
However, there are examples where, even though one side performing would require laws
to be broken, a contract is still enforced, that is, a remedy is still supplied for breach.
Three examples from the book:



“A married man may be liable for inducing a woman to rely on his promise of
marriage, even though the law prohibits him from marrying without first
obtaining a divorce.”
“A company that fails to supply a good as promised may be liable even though
selling a good with the promised design violates a government safety regulation.”
“A company that fails to supply a good as promised may be liable even though
producing the good is impossible without violating an environmental regulation.”
In all these examples, the liability rests with the party that knew, or should have known,
that it was committing to something illegal. Similar to the reasoning in Ayres and
Gertner, putting the liability on the informed party gives them an incentive to be honest
(or in these cases, to not enter into this type of contract). Thus, Cooter and Ulen argue
that the promisor should be liable for breach if he knew (or should have known) that the
promise was illegal but the promisee did not. On the other hand, the promisor should not
be liable if he did not know the promise was illegal and the promisee did.
Derogation of public policy is an example of an immutable rule, or a regulation – a rule
that the parties to a contract cannot overrule. Most of what we’ve done up to now has
been focused on default rules – rules which hold when the parties chose not to overrule
them.
For example, we said that expectation damages lead to efficient breach, and that they
were therefore a good rule for contracts that did not specify damages. However, we
never said that expectation damages should be a mandatory rule – that is, we never said
parties should not be able to specify a different remedy for breach.
One interesting application of both this principle is the case of Peevyhouse v Garland
Coal and Mining Company, decided by the Supreme Court of Oklahoma in 1962.
Peevyhouse owned a farm in Oklahoma, and Garland contracted to strip-mine some coal
on the property. The contract specified that Garland would take certain steps to restore
the property to its previous condition after mining the coal.
After mining the coal, Garland made no attempt to take these restorative steps, which it
was estimated at trial would have cost $29,000. Peevyhouse sued for about that much
($25,000). The parties agreed during trial that everything else in the contract had been
performed. The defendant introduced evidence that although the damage would cost
$29,000 to repair, it lowered the value of the plaintiffs’ farm by only $300. (The
“diminution in value” of the farm due to the damage was $300.)
The original jury awarded Peevyhouse $5000 in damages, and both parties appealed to
the Oklahoma Supreme Court – Peevyhouse saying this was less than the service that had
been promised, Garland saying this was still more even than the total value of the farm
after repairs.
The OK Supreme Court reduced the damage award to $300.
At first glance, this seems like a nice example of efficient breach – performing the last
part of the contract would cost $29,000, and benefit the Peevyhouses by $300, so it is
efficient to breach and pay expectation damages, which is what was awarded.
However, the dissenting opinion noted that the coal company was well aware of what
they were getting into when they signed the contract. Most coal mining contracts at that
time contained a standard per-acre diminution payment, that the coal company paid
instead of repairing the property. The Peevyhouses specifically rejected that clause of the
contract during initial negotiations, and would not sign the contract unless it specifically
promised the restorative work. The dissent argued that the Peevyhouses were therefore
entitled to “specific performance” of the contract, that is, to have the restorative work
completed as promised.
Even though objectively, the damage to the property diminished its value by only $300,
the Peevyhouses’ subjective value appears to have suffered much more. Expectation
damages are meant to make the promisee as well off as they would have been under
performance – here, this seems not to be the case.
At least one scholar has claimed that the judges who decided Peevyhouse were either
incompetent or corrupt – one was later impeached, and others resigned – although others
have disagreed. Still, it appears that the ruling here attempted to turn an efficient default
rule – expectation damages – into a mandatory rule, that is, a rule that would be enforced
even when it was not what the parties intended at the time of the contract.
Next, I want to discuss a number of ways to get out of a contract, that is, conditions under
which a contract will not be enforced.
These are typically divided into two categories: formation defenses and performance
excuses. A formation defense is a claim that a contract does not exist: that the
requirements for a contract to be valid were not met. (Under the bargain theory, for
example, a formation defense might be that consideration was not given.) A performance
excuse is a claim that, even though there is a contract, you should be excused from
performing.
We said earlier that, under Coase, when individuals are rational and there are no
transaction costs, voluntary negotiations should lead to efficiency. So refusing to enforce
voluntary contracts does not generally make sense in these cases. Thus, most of the
doctrines for invalidating a contract can be explained as a violation of one of these
assumptions: either the individuals agreeing to the contract were not rational, or there was
some sort of transaction cost or market failure.
The first exception is that courts will generally not enforce contracts made by irrational
individuals. There are several ways that this can happen. For example:


children cannot sign binding contracts
the legally insane cannot sign binding contracts
These both fall under the doctrine of incompetence: one party to the contract was not
competent to enter into a binding agreement. In fact, the law does not automatically
invalidate all contracts made with children or insane people; it only invalidates contracts
which were not in their best interests. (Basically, the law creates an incentive not to cheat
people who can’t take care of themselves.)
are drunk people incompetent?
Last year, after I introduced the doctrine of incompetence, one of my students emailed me
an excellent question: what if you signed a contract while drunk?
Can a drunk person sign a legally enforceable contract, or would the fact that he was
drunk get him off the hook?
Recall that the bargain theory required a “meeting of the minds” to agree to a contract,
and it’s reasonable to question whether this could occur with someone who was drunk.
However, the general rule in the U.S. is this:
You have to be really, really, really drunk for the contract not to count.
OK, fine, that’s not how it’s written in the case law. The rule is, for a contract to be
unenforceable, you need to have been “intoxicated to the extent of being unable to
comprehend the nature and consequences of the instrument he executed.” Basically, not
just drunk enough to have bad judgment, but drunk enough to have no idea of what
you’re doing.
There’s a classic case that upheld this standard, Lucy v Zehmer, decided by the Supreme
Court of Virginia in 1954. First of all, it’s a little embarrassing when your drunken antics
end up in front of a state supreme court. But the case makes for fun reading.
Basically, the Zehmers owned a farm, and the Lucys had been trying to buy it from him
for a long time. (Several years, multiple offers, beginning at $20,000.) One night,
Zehmer’s out drinking, runs into Lucy, they continue to drink, and at some point, Lucy
says something like, “I bet you’d sell that farm for $50,000.” Zehmer says, “You don’t
have $50,000.” Lucy says, “I can get it!” Zehmer says, “No you can’t!” They argue for
a while about whether Lucy can raise $50,000, then Lucy says, “Write it down!”
So Zehmer grabs a discarded guest check (seriously), turns it over, and writes on the
back, “I agree to sell such-and-such farm to this guy for $50,000.” It was revealed at trial
that he had, among other things, misspelled the name of the farm and the word
“satisfactory”.
Lucy says, “Hold on a second, your wife owns it too!” So Zehmer crosses out the word
“I”, replaces it with “We,” and walks to the other end of the bar where his wife is sitting.
Tells her to sign it, she says, “What?” He whispers to her, don’t worry, it’s just a joke,
we’re not selling the farm, so she signs it. They add a couple more legal terms to make it
look like a contract (giving the Lucys the right to check the validity of the title), he brings
it back, Lucy takes the contract and puts it in his pocket. Monday morning, Lucy goes to
the registry of deeds to check the title, starts raising the money, and contacts Zehmer to
carry out the contract. Zehmer says, “What?”
Zehmer refuses to honor the contract, Lucy sues for specific performance, that is, asks the
court to force Zehmer to sell him the farm at the agreed price.
There was some dispute during trial about exactly how drunk Zehmer was, but it was
ruled that while he was clearly drunk, he was not so drunk as to be “unable to
comprehend the nature and consequences” of what he was doing – he knew the contract
was to sell the farm. (For one thing, a little while later, Zehmer’s wife asked him to drive
her home.) Most of the opinion seemed to center on whether Lucy knew that Zehmer
was joking when he wrote what looked like a proper, if unusual, legal contract. The court
basically ruled that it wasn’t Lucy’s job to know Zehmer was joking – that is, Zehmer
may have thought he was joking, but it looked to Lucy like he was serious. Zehmer
behaved exactly as he would have behaved if he were drunk but actually wanted to sell
the farm; which was good enough.
Even if Zehmer didn’t really have the intent necessary to enter into a contract, not being
too quick to invalidate a contract on the grounds that one of the parties was drunk, or
joking, seems like a pretty good rule for pragmatic reasons. If the rule went the other
way, it seems there would an awful lot of litigation over exactly how drunk someone was
when a contract was signed. Not to mention a lot more contracts being signed in bars, to
give the parties an easy way out; or a lot of lawyers carrying breathalyzers to make sure
their contracts would be enforceable. Basically, a more nuanced rule would be extremely
difficult and costly to enforce, so we seem to accept the cost of an occasional person
making a bad decision while drunk, in order to keep the system working well the rest of
the time.
Of course, that’s not quite the final word on drunkenness. If you were visibly drunk –
that is, the other party clearly knew you were drunk – the court might be receptive to
finding the contract unenforceable for other reasons we’ll get to shortly, such as fraud
(you were tricked into signing) or unconscionability (the contract is too one-sided). I
suspect that if Zehmer had agreed to sell the farm for $10, the contract would not have
been upheld; but that since the terms seemed reasonable, it was. However, if you’re
drunk and hide it well, you generally won’t get out of a contract that way.
(One more example of this is the Borat lawsuits. Two of the frat boys who ended up
looking like racist a-holes in the movie Borat sued, basically saying that they were
tricked into signing the releases to be in the movie. It appears the movie’s producers may
have gotten them drunk and then asked them to sign the releases, and may have lied to
them a lot (telling them the movie was only going to be released in Europe, they wouldn’t
release the frat boys’ names, or college, or frat).
Part of the problem for them is that the releases contained what are called “merger
clauses”, which basically say, it doesn’t matter what else we already told you, all we’re
agreeing to is what’s in this contract. (Basically, any prior verbal agreement is “merged
into” this one, which is the only thing we’re agreeing to.) It’s kind of sneaky, but it does
seem to legally absolve the producers of anything they told the frat boys to get them to
sign but that wasn’t in the contract. Again, just being drunk doesn’t get you out of a
contract. One of the fratboys seemed to find it relevant that he was under the drinking
age; but that, if anything, would make the producers liable in criminal court (for
supplying alcohol to a minor), but not invalidate the releases. (It’s also been established
that the frat boys were all already heavy drinkers, surprisingly.)
As far as I know, the lawsuits have all been dismissed, and the frat boys got nothing.)
(Since they’re not in the textbook; for the opinion in the Lucy v Zehmer case, which
really does make great reading, see
http://www.finance.pamplin.vt.edu/faculty/sds/Lucy.pdf
For an overview of the legal issues in the Borat lawsuits, see a piece by Julie Hilden, with
the brilliant title “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for
Make Benefit Guileless Americans in Film” at
http://writ.corporate.findlaw.com/hilden/20061129.html
)
So the moral of the story, I suppose, is don’t get drunk with people who might ask you to
sign contracts.
Back to contract law, and another situation in which we would not expect people to act
rationally:

courts will not enforce contracts signed under dire constraints, specifically,
duress and necessity
Necessity is when I’m at the point of starvation, and someone comes along and offers me
a sandwich for $10,000. I don’t have it on me, so I sign a contract agreeing to pay him
$10,000 and I eat the sandwich. Or I’m on a boat that’s about to sink, and another boat
offers me a ride back to shore for a million dollars. In either case, the contract would not
be upheld, since I signed it out of necessity.
Duress is similar, but when the uncomfortable situation is being caused by the other
party. This is when someone kidnaps my child, and I agree to pay ransom to get her
back. The contract is not enforceable, because I agreed to it under duress. As much as
everyone loved the idea of “making him an offer he can’t refuse” from the Godfather,
courts would not uphold a contract signed at gunpoint. (Of course, whether you want to
breach a contract with the Mafia, or sue the Mafia, is a separate question.)
It’s not that hard to argue against holding you responsible for promises made under
duress or necessity based on notions of fairness and morality. The Friedman book
(Law’s Order) tries to understand these in straight economic terms.
Duress
Friedman begins with an example of duress. A mugger approaches you in an alley and
threatens to kill you unless you give him $100. You don’t have $100 on you, but he says
he’ll accept a check. When you get home, can you stop payment on the check? Or do
you have to honor the agreement you made?
Clearly, he wants the agreement to be enforceable; he’d rather have $100 than kill you.
And if you believe he’ll kill you if you don’t give him the money, then you clearly want
it to be enforceable as well. So making the contract enforceable seems to be a Paretoimprovement. So what’s the problem?
The problem, of course, is that even if such a contract is a Pareto-improvement once
you’re in the situation, making such contracts enforceable encourages more muggings,
since it increases the gains. So refusing to enforce contracts signed under duress seems to
trade off a short-term “loss” – the efficiency lost by ruling out some mutually beneficial
trades – against creating less incentive for the bad behavior that put you in that situation
in the first place.
(The fact that there is a tradeoff here implies that it may not be optimal to rule out
enforceability under every instance of duress. For example, peace treaties can be thought
of as contracts signed under duress – the losing side is facing the threat of continuing to
battle a superior force. Most people agree that peace treaties being enforceable is a good
thing. Peace treaties are clearly a good thing “ex post” – they make war less costly, by
ending it more quickly. Perhaps by making war less costly, they encourage more wars –
but it seems unlikely that this has much effect. It’s probably efficient for peace treaties to
be enforceable, but for promises made to a mugger to be unenforceable.)
Necessity
However, the logic that tells us that contracts with muggers shouldn’t be enforced doesn’t
work for contracts signed under necessity.
You’re out sailing on your $10 million boat and get caught in a storm. The boat starts
taking on water and slowly begins to sink. A tugboat comes by and offers to tow you
back to shore, if you pay him $9 million. If not, he won’t leave you to die – he’ll give
you and your crew a ride back to shore, but your boat will be lost.
With duress, we argued that making the contract enforceable would encourage muggers
to commit more crimes, which is bad. But here, making the contract enforceable would
encourage tugboats to make themselves available to rescue more boats – so how is that a
bad thing?
In fact, Friedman points out that if we consider the tugboat captain’s decision beforehand
– how much to invest in being in the right place at the right time – the higher the price,
the better. The total gain (to all parties) from the tugboat being there is the value of your
boat, minus the cost of rescuing it – say, $10,000,000 - $10,000 = $9,990,000. Allowing
the tugboat to recover the entire value of the boat would make his private gain from
rescuing you exactly match the social gain – which would cause the tugboat captain to
invest the socially optimal amount in being available to rescue you!
But on the other hand, consider your decision about whether to take your boat out on a
day when a storm is a possibility. Suppose there’s a 1-in-100 chance of being caught in a
storm; and if you are caught in a storm, there’s a one-in-two chance a tugboat will be
there to rescue you.
If he can charge you the full value of your boat, then when weighing the costs and
benefits of going sailing that day, you consider a 1-in-100 chance of losing the full value
of the boat. That is, in your analysis of whether it’s worth sailing, you’ll include the
1/200 possibility the boat sinks, and the 1/200 possibility you pay its full value to an
opportunistic tugboat captain – a total expected cost of $100,000. So you’ll only go
sailing on days where your benefit is greater than $100,000.
But when you go sailing and start to sink, half the time, your loss is the tugboat captain’s
gain. The social cost of you sailing includes a 1-in-200 chance the boat is lost, plus a 1in-200 chance it has to be towed to shore; for an expected cost of
$10,000,000 / 200 + $10,000 / 200 = $50,050. So efficiency says you should go out
sailing whenever the benefit to you is greater than $50,050.
So if the tugboat captain is able to charge you the full value of the boat, you will
“undersail” – that is, in cases where your private gain from sailing is between $50,050
and $100,000, efficiency would suggest you should sail, but since the private cost
outweighs the benefit, you choose not to.
On the other hand, suppose the tugboat could only charge you the cost of the tow. Then
the social cost of sailing would match the private cost to you - $50,050. This would lead
you to go sailing exactly the efficient amount.
Friedman, then, makes the following point. The same transaction sets ex-ante incentives
on both parties; and the price that would lead to an efficient decision by one of them,
would lead to an inefficient decision by the other.
So, what to do? As Friedman puts it, “put the incentive where it will do the most good.”
Somewhere in between the cost of the tow and $10 million is the “least bad” price – the
price that minimizes the losses due to inefficient choices by both sides. If the tugboat
captain is more sensitive to incentives than you are, the best price is likely closer to the
value of the boat; if you respond more to incentives than he does, the best price may be
closer to the cost of the tow. But regardless of the details, two things will generally be
true:


the least inefficient price is somewhere in the middle
and there’s no reason for it to be the price that would be negotiated during the
storm
That is, once you’re caught in a storm, all the relevant decisions have already been made
– you’ve decided whether to sail, the tugboat captain has decided whether to be out there
looking for sinking sailboats. Those are like sunk costs – they don’t affect your
bargaining position now. So there’s no reason that, if you bargained over saving your
boat during the storm, you’d end up anywhere near that efficient price. On the other
hand, there’s always the risk that bargaining breaks down and you refuse the tugboat
captain’s offer, incurring a large social cost (the value of the boat minus the tow is lost).
So from an efficiency point of view, it makes sense for courts to step in, overturn
contracts that were signed under necessity, and replace them with what would have been
ex-ante optimal terms. This takes away the need to bargain hard during the storm,
ensuring that the boat is saved; and it creates the “least bad” combination of incentives.
So that’s Friedman’s take on duress and necessity.
(There’s an important point here: that a single price creates multiple incentives, which
cannot all be set efficiently. Another example: expectation damages set the incentive to
breach the contract efficiently – that is, lead to efficient breach; but they set a different
incentive incorrectly – the incentive to sign the contract in the first place. If you will owe
expectation damages under circumstances that favor breach, the private cost of those
circumstances is higher to you than the social cost, so you may forego some contracts that
would be overall value-creating. Later on, we’ll come to a different type of damages
which would lead to efficient signing decisions, but inefficient breach. Again, it’s
impossible to set both incentives correctly at the same time.)
To go a little bit further with this.
We just said that the law will not enforce contracts signed under threat of harm – “give
me $100 or I’ll shoot you.”
However, lots of negotiations involve threats of some sort – “give me a raise or I’ll quit
and work for your competitor,” “$3000 for my car is my final offer, take it or I walk.”
This kind of threat is fine – it’s often necessary to tease out both sides’ threat points and
figure out whether cooperation is efficient or not.
To distinguish between the two types of threats, note what happens in each case when
bargaining fails. In the second case, failure to reach a bargain results in a failure to create
more value. In the first case, failure to agree leads to destruction.
In addition, successful bargains tend to create value, while contracts created under duress
tend to just shift resources from one owner to another.
In general, the following rule applies to distinguish duress: a promise is enforceable if it
was extracted as the price of cooperating in creating value; a promise is
unenforceable if it was extracted by a threat to destroy value.
The textbook gives a nice example of this. The captain of a boat hires a crew in Seattle
for a fishing expedition to Alaska. Once they reach Alaska, the crew demands higher
wages. After they return to Seattle, the captain refuses to pay the higher wages, claiming
he agreed to them under duress.
While in Seattle, the crew that signed on faced competition from other fishermen. Once
in Alaska, they did not. The captain had relied on the promise – by investing in fuel and
supplies, and the time to sail to Alaska.
While in Seattle, the crew’s only threat was to not cooperate in creating value – in which
case the captain could have hired another crew. Once in Alaska, the crew’s threat was to
destroy value – by destroying the investment the captain had already made.
We also gave the principle earlier that contracts, including renegotiated contracts, should
be enforceable if both parties wanted them to be enforceable at the time of the agreement.
In this case, think what happens if the renegotiated contract will not be enforceable. The
crew is still better off fishing (and getting paid their original wages) than return to port
with no fish and not get paid. So while the crew may want the contract renegotiated
under duress to be enforceable, the captain does not; courts would tend not to enforce it.
On the other hand, suppose that half way into the voyage, circumstances change – the
weather gets worse, or a message arrives that makes the crew want to return home. Now
the captain offers them higher wages to get them to stay. In this case, both sides would
like the new promise to be enforceable, since without it the ship would have to return
home.
In general, when a contract is renegotiated under duress will not be enforced; but a
contract that is renegotiated under changed circumstances will.
Like duress, a contract made under necessity is made with the threat of destruction.
Under duress, the threat was destruction via action. Under necessity, the threat is
destruction via inaction. (The tugboat captain isn’t threatening to sink your boat, just to
let it sink. If you run out of gas on a remote road and a passing driver offers you gas for
$100 a gallon, he isn’t threatening to shoot you, just to drive off and let you starve.)
While contracts made under necessity are generally not enforced, rescuers are generally
entitled to some reward, to create an incentive to perform the rescue in the first place.
Impossibility
Another doctrine that will make some contracts unenforceable is impossibility. A
surgeon agrees to perform an operation, then breaks his hand in a hideous golf cart
accident the weekend before. Clearly, he cannot perform the operation; the question
remains as to whether he is excused from performing, or owes damages.
Perfect contracts would specify who would bear that risk. Of course, due to transaction
costs, real contracts will generally not address risks that are very remote. In some cases,
the contract, while not addressing a risk explicitly, may give clues as to how the gap
should be filled. An example from the book: a drilling company agrees to drill a well for
a landowner, but the drill runs into impenetrable granite. Suppose that the driller was
competing with other companies for the offer, but the landowner agreed to a price much
higher than the competition. The court might feel that the driller was implicitly
guaranteeing performance, and should owe damages when performance became
impossible. Or industry custom might be for one side or the other to bear that risk.
In situations where neither the contract itself nor the custom of the industry assigns the
risk, the law has to. In most typical cases, the promisor is liable for breach, even when
the breach is not his fault. (Contract liability is strict.) So a construction company that
finishes a building late due because or unexpected complications is generally liable.
However, there are some instances where non-performance is excused by physical
impossibility. A famous artist agrees to paint someone’s portrait, and then dies; his estate
does not owe for the breach of the promise. A manufacturer whose factory burns down
might be excused from performance. Similarly, breach is typically excused if
performance became illegal. A shipping company commandeered to carry military cargo
during a war is excused from its civilian commitments.
One legal theory in these cases is that an unexpected contingency destroyed “a basic
assumption on which the contract was made”. The painter assumed he would be alive;
the manufacturer assumed its factory would not burn down. Under this theory, if a
contract is made in good faith and then events destroy one of its basic assumptions,
breach is excused.
The question then becomes, when is something a “basic assumption” and when is it not?
The book sidesteps this question, and instead moves to what efficiency would require:
Efficiency requires assigning liability to the party who can bear the risk at least cost.
That is, nonperformance due to impossibility is just another type of risk; so for efficiency,
it should be allocated to whichever party is the low-cost bearer of the risk.
In many cases, one party can take precautions to minimize the risk – the manufacturer
can install sprinklers in his factory, the painter can prioritize commissioned pieces over
other work, and so on. In those cases, that party is typically the low-cost avoider, and
efficiency suggests they should bear the risk.
When the risk cannot be reduced, the book claims that liability should lie with the party
who can best spread the risk, through insurance or diversification.
(We already saw the general principle of gap-filling by allocating risk to the low-cost
avoider, that is, the person who can most cheaply mitigate or bear the risk. The rationale
is that this is what the original contract would have done, if it had bothered to consider
that risk.)
Misinformation
There are four doctrines in contract law that excuse breach if a promise was made due to
bad information:
 fraud
 failure to disclose
 frustration of purpose
 mutual mistake
In the grasshopper example from day 1 of contract law, the seller of “a sure method of
killing grasshoppers” defrauded the customer by deliberately tricking or misinforming
him; the contract between them would not be enforced, so the customer would get his
money back.
Fraud violates the “negative duty” not to misinform the other party in a contract. In some
circumstances, parties also have a positive duty to disclose certain information – but this
is not always the case.
In the civil law tradition, a contract may be void because you did not supply the
information that you should have.
In many common law situations, a seller is required to warn the buyer about hidden
dangers associated with a product, such as the side effects of a drug.
In the common law, however, there is not a general duty to disclose information that
makes a product less valuable without making it dangerous. Under the common law, a
used car dealer does not have to tell you every flaw about a car he is selling you, although
he cannot lie about these faults if you ask him.
(On the other hand, a new car comes with an “implied warranty of fitness” – the seller of
a new car must return the purchase price if the car proves unfit to perform its basic
function, transportation.)
Fraud and failure to disclose are situations where one party is misinformed. There are
also situations in which both parties to a contract are misinformed. When both parties
base a contract on the same misinformation, the contract will often not be enforced based
on the doctrine of frustration of purpose. An example of this comes from the English
law treatment of the Coronation Cases. In the early 1900s, rooms in buildings along
certain streets in London were rented in advance for the day of the new king’s coronation
parade. The new king became ill, and the coronation was postponed. The renters, then,
did not want the rooms, but some of the owners tried to collect the rent anyway. The
courts ruled that a change in circumstance had “frustrated the purpose” of the original
contracts, and refused to enforce them.
Frustration of purpose would also presumably void the agreement if you won an auction
for an expensive painting, and then you and the seller both discovered it was a forgery.
When the parties to a contract base the agreement on different misinformation, it is a case
of mutual mistake. One of our early examples featured a beat-up Chevy and a shiny
new Cadillac. The seller believed he was negotiating the sale of the Chevy; the buyer
thought she was negotiating the purchase of the Cadillac. In this case, the court would
typically invalidate the contract based on mutual mistake and simply return the buyer’s
money and the seller’s keys.
Return to the doctrine of frustration of purpose, which we saw with the coronation
cases. A bunch of Londoners rented rooms with a view of the new king’s coronation
parade; the parade was postponed, so they no longer wanted the rooms. An unexpected
contingency made performance of the original contracts pointless.
Just like impossibility is a doctrine for assigning the risk that performance becomes
impossible, frustration of purpose is a doctrine for assigning the risk that performance
becomes pointless. The same economic principle, then, says,
When a contingency makes performance pointless, assign liability to the party who
can bear the risk at least cost.
In this case, the property owners could eliminate their losses by renting the rooms a
second time, for the rescheduled parade. Thus, there was hardly any cost to the owners
from bearing the risk; so efficiency would seem to allocate the risk to them, which is
what happened.
Frustration of purpose is what a contingency arises after the contract is signed that makes
performance pointless. Mutual mistake about facts can be thought of as a contingency
already having arisen before the parties signed the contract, but without their knowledge.
Suppose a buyer contracts to buy some land with timber on it. As it happens, the timber
was destroyed by forest fire the day before the contract was signed, but neither knew
about it.
The owner at the time of the accident is usually the low-cost avoider of the risk – that is,
the buyer is unlikely to be able to prevent forest fires on someone else’s land – so this
generally entails not enforcing the contract. Personally, I was perfectly comfortable with
the doctrine of just unwrapping contracts based on mutual mistake, but this gives some
economic relevance to it.
Another type of mutual mistake is mutual mistake about identity, as in the case of the
rusty Chevy and the new Cadillac from three weeks ago. When there is mutual mistake
about the object being sold, enforcing the contract would have the effect of making an
involuntary exchange. We assume that voluntary exchange is efficient; involuntary
exchange may not be. So efficiency agrees with the doctrine of setting aside contracts
based on mutual mistake of this type.
Another important principle is one that we saw illustrated in Hadley v Baxendale, the
miller with the broken crankshaft. In that case, heavy losses were incurred because the
party with information – Hadley, who knew how time-critical his shipment was – was not
the party who was making decisions – Baxendale, who chose to ship the crankshaft by
boat instead of train. This brings us to a general principle about information:
Efficiency generally requires uniting knowledge and control.
If I value some land more than you, it may be because I have knowledge of a way to
derive more value from the land. (The land has coal underneath, and I know how to mine
it; or the land is good for growing tomatoes, and I know how to grow tomatoes.) In those
cases, selling the object to the party who values it more unites knowledge and control,
and therefore increases efficiency.
(Cooter and Ulen go a little further, and say, efficiency requires uniting knowledge and
control over resources at least cost, including the transaction costs of transmitting
information and selling goods.)
As a general principle, then, contracts that unite knowledge and control should generally
be upheld, and contracts that separate knowledge and control should more often be set
aside. This gives us a way to look at the doctrines related to information.
When we looked at mutual mistake, neither party had correct information, so the contract
neither united nor separated knowledge and control. Thus, we did not discuss it in those
terms. However, there are situations where one party to a contract has mistaken
information and one does not. This is called unilateral mistake.
For example, suppose you have an old car and you think it’s just a worthless old car, but I
know it’s a classic and worth a lot of money. I agree to buy it from you at a low price,
and afterwards, you learn the truth. The contract was based on unilateral mistake – you
were wrong about the value of the car, but I knew the truth.
In these cases, the contract is generally enforced. While mutual mistake may be cause to
set aside a contract, unilateral mistake is generally not.
This makes sense for two reasons. First, if I know the car is more valuable and manage
to buy it from you, this unites knowledge and control. I probably know the car is
valuable because I’m more into classic cars, and will thus take better care of it. Much as
it’s disappointing to you to get screwed out of something valuable, this may well be
efficient.
And second, this creates an incentive to gather information. Sometimes gathering
information is costly; and often, having better information leads to efficiency. Rewarding
people for having better information (allowing them to profit from it) leads to an
incentive to gather information, which may be a good thing.
(Of course, if you sued to try to void our contract, it would put me in a funny position.
Since mutual mistake is a valid formation defense, you could claim neither of us knew
the true value of the car when you sold it to me; so now I have to get up in court and
claim, no, I wasn’t ignorant, I was trying to rip you off. And if I can convince the court I
was trying to rip you off, I get to keep the car. Weird.)
There was a famous case in 1815 that concerned unilateral mistake, Laidlaw v Organ.
During the War of 1812, the British blockaded the port of New Orleans, which depressed
the price of tobacco, since nobody could make money exporting it. Organ was a tobacco
buyer; he received private information that a treaty had been signed, ending the war, and
negotiated with the Laidlaw firm, which did not know about the treaty, to buy some
tobacco at the depressed price. The next day, news broke that the war was over, the price
of tobacco soared, and Laidlaw sued.
Despite it being a unilateral mistake – Organ knew the war was over, Laidlaw did not –
the contract was set aside at trial. It was appealed to the Supreme Court, who ruled that
Organ was not bound to communicate his knowledge and ordered a retrial. Things get a
little fuzzy from there, and the doctrine does not seem to be rock-solid; but nonetheless,
unilateral error is generally taken as not being a valid reason to void a contract.
To understand the situation on economic grounds, Cooter and Ulen draw a distinction
between productive information – information that can be used to produce more wealth
– and redistributive information – information that can be used to redistribute wealth in
favor of the informed party. Productive information could be that farmland is resting
atop valuable underground minerals, or a water route between Europe and China.
Redistributive information could be that the state plans to build a highway through a
particular piece of land, changing property values nearby.
Since productive information increases total wealth, efficiency demands giving incentives
for people to discover productive information; since redistributive information does not
create additional wealth, efficiency does not require giving incentives to discover it.
Thus, letting people profit from productive information – by enforcing contracts signed
under unilateral error – is good; letting people profit from redistributive error is bad.
They also point out that to create incentives, information only needs to be rewarded when
it was acquired through effort or investment, not by chance. Thus, they come to the
principle:
Contracts based upon one party’s knowledge of productive information – especially
if that knowledge was the result of active investment – should be enforced, whereas
contracts based upon one party’s knowledge of purely redistributive information or
fortuitously acquired information should not be enforced.
Unfortunately, information is often a mixture between productive and redistributive.
Without much explanation, Cooter and Ulen suggest enforcing “most” contracts based on
mixed information.
Duty to Disclose
We talked earlier about the duty to disclose – the fact that sellers must inform buyers
about any hidden safety risks associated with their product. The rationale is fairly
obvious.
So safety information is treated separately from productive and redistributive
information. The law does not generally require disclosure of either productive or
redistributive information to a buyer, but does require the disclosure of safety
information.
While common law sellers generally do not have a duty to disclose anything besides
safety information, there have been exceptions. In Obde v Schlemeyer (1960), a seller
knew his building was infested with termites and did not tell the buyer, who discovered
the termites after the fact and sued.
The termites should have been exterminated immediately to prevent further damage; the
court in Obde deviated from tradition and imposed a duty to disclose.
We talked earlier about uniting knowledge and control. In this case, the seller knew
about the termites and the buyer did not; so the sale separated knowledge from control.
So efficiency seems to support the ruling in Obde.
In Obde, the seller did not offer the fact that the building had termites, but also did not lie
about it – the buyer didn’t ask. If the buyer had asked, and the seller claimed there were
no termites, we would have been in the case of fraud. Victims of fraud are generally
entitled to damages in the amount of the harm caused by the fraud.
The reasoning here is clear: if parties know fraudulent contracts will not be enforced,
they can rely on the truthfulness of the other party’s statements, rather than having to
incur the costs of verifying everything for themselves. This lowers transaction costs of
completing agreements, which is one of the goals of contract law.
Courts and legislatures have begun imposing a duty to disclose in certain situations.
Lenders now must disclose the APR on all consumer loans. Many states require used car
dealers to reveal major repairs done on the car being sold. Many states require sellers of
homes to reveal certain types of defects. Such requirements are meant to improve
information exchange and lower transaction costs. Whether doing so outweighs the cost
of enforcing them is a separate question.