Lecture 13 – more ways to get out of a contract

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Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 13
Logistics
 HW3 is online, due next Thursday (Mar 15)
 First midterm will be returned at end of lecture
 Second midterm March 26


Cumulative, through end of contract law
More weight on more recent material
1
Monday…
 Contracts which won’t be enforced

Derogation of public policy
 Formation defenses and performance excuses



Incompetence (but not drunkenness)
Duress and necessity
Impossibility, and determining the efficient bearer of a risk
 Today: more ways to get out of a contract, and remedies
for breach
2
Discussion question
 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?
3
Contracts based on
bad information
4
Contracts based on faulty information
 Four doctrines for invalidating a contract

Fraud

Failure to disclose

Frustration of purpose

Mutual mistake
5
Fraud
 Fraud: one party was deliberately tricked
source: http://www.wyff4.com/r/29030818/detail.html
6
What if you trick someone by withholding
information?
 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
7
Duty to disclose under common law
 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)
8
Duty to disclose under common law
 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…
9
What if both parties were misinformed?
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”
10
What if both parties were misinformed?
Frustration of Purpose

Change in circumstance
made the original promise
pointless
Mutual Mistake

Mutual mistake about facts



Coronation Cases

“When a contingency
makes performance
pointless, assign liability to
party who can bear risk at
least cost”

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
11
Another principle for allocating risks
efficiently: uniting knowledge and control
 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
12
Mutual vs. Unilateral Mistake
 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
13
Unilateral mistake
 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
14
Unilateral mistake: Laidlaw v Organ (U.S.
Supreme Court, 1815)
 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
15
Uniting knowledge and control
 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
16
Unilateral mistake: productive versus
redistributive information
 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
17
Other reasons a contract
may not be enforced
18
Vague contract terms
 Courts will generally not enforce contract terms that are
overly vague
 Can be thought of as a penalty default


“Punish” the parties by refusing to enforce contract…
…so people will be more clear when they write contracts
 But some exceptions

Parties may commit to renegotiating the contract “in good faith”
under certain contingencies
19
Adhesion (I): “Shrink-wrap” licenses
 Back when software came on disks or CDs…


Box was wrapped in cellophane
Inside, “By unwrapping this box, you agree to the following terms…”
“Due to the unscheduled trip to the
autowrecking yard the school bus
will be out of commission for two
weeks. Note by reading this letter
out loud you have waived any
responsibility on our part in
perpetuity throughout the known
universe.”
 Contract is not binding if one party had no opportunity to
review it before agreeing
20
Adhesion (II): What if a party chose not to
review the contract?
Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/
21
Adhesion (II): What if a party chose not to
review the contract?
 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.”
22
Adhesion (general)
 Contract of Adhesion: standardized “take-it-or-leave-it”
contract where terms are not negotiable

“Bogus duress”
 Not illegal per se, but might attract “closer scrutiny”

A few state courts have adopted a rule: if I have “reason to believe
that the other party would not agree if he knew the contract
contained a particular term, the term is not part of the agreement”
23
What if you signed a contract that was
dramatically unfair?
 Under bargain theory, courts should ask only whether a
bargain occurred, not whether it was fair

Hamer v Sidway (drinking and smoking)
 But both common and civil law have doctrines for not
enforcing overly one-sided contracts




Unconscionability/Lesion
“Absence of meaningful choice on the part of one party due to
one-sided contract provisions, together with terms which are so
oppressive that no reasonable person would make them and no
fair and honest person would accept them”
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”
24
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “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.”
25
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “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.”
26
Unconscionability: Williams v WalkerThomas Furniture (CA Dist Ct, 1965)
 “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
27
Remedies for breach
of contract
28
Three broad types of remedy for breach of
contract
 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
29
Expectation damages
 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
30
Reliance damages
 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
31
Opportunity cost damages
 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
32
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Purdue 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
whatever pre-game investments I made
33
Example: expectation, reliance, and
opportunity cost damages
 You agree to sell me ticket to Wisconsin-Purdue 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
whatever pre-game investments I made
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)
34
Ranking damages
Contract
I Sign

Best
Alternative

Do Nothing
=
=
=
Breach +
Expectation
Damages

Breach +
Opportunity Cost
Damages

Breach +
Reliance
Damages

Opportunity Cost
Damages

Reliance
Damages
Expectation
Damages
$100
$80
$15
35
Hawkins v McGee (“hairy hand case”)
 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
36
Hawkins v McGee (“hairy hand case”)
+ Opp Cost
Damages
+ Reliance
Damages
Initial Wealth
Opp Cost Damages
Reliance Damages
+ Expectation
Damages
Expectation Damages
$
Hand
Hairy Scarred
Next
best
doctor
100%
Perfect
37
Other court-ordered remedies
 Restitution

Return money that was already received
 Disgorgement

Give up wrongfully-gained profits
38
Other court-ordered remedies
 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
39
Expectation damages vs. specific performance
 Peevyhouse v Garland Coal and Mining Co
(OK Supreme Court, 1962)






Garland contracted to strip-mine
coal on Peevyhouse’s farm
Contract specified Garland
would restore property to original
condition; Garland did not
Restoration would cost $29,000
But “diminution in value” of farm
was only $300
Original jury awarded $5,000 in
damages, both parties appealed
OK Supreme Court reduced
damages to $300
40
Expectation damages vs. specific performance
 At first, sounds like a perfect example of efficient breach



Performing last part of contract would cost $29,000
Benefit to Peevyhouses would be $300
Efficient to breach and pay expectation damages, which is what
happened
 But…




Most coal mining contracts: standard per-acre diminution payment
Peevyhouses refused to sign contract unless it specifically
promised the restorative work
Dissent: Peevyhouses entitled to specific performance
(Peevyhouses seemed to value condition of property much more
highly than change in market value)
41
Think about Peevyhouse in terms of penalty
defaults
 Contract promised restoration work, didn’t specify remedy if
it wasn’t performed
 Which default rule works better:


Default rule allowing Garland to breach and pay diminution fee?
Default rule forcing Garland to perform restoration work?
 Ayres and Gertner: default rule should penalize the betterinformed party





Garland routinely signed contracts like these
Peevyhouses were doing this for the first time
Default rule allows Garland to pay diminution fee: they have no
reason to bring it up, Peevyhouses don’t know
Default rule forces Garland to do cleanup: if that’s inefficient, they
could bring it up during negotiations
42
In this case, specific performance would serve as a penalty default
Party-designed remedies
 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
43
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
 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
44
Liquidated 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
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay damages
(-14,700, 44,700)
 If damages limited to liquidated damages…



Peevyhouses shouldn’t believe restorative work will get done
So Peevyhouses better off refusing to sign
Even though mining and restoring Pareto-dominates
45
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
Peevyhouses
Don’t
Sign
Garland Coal
(0, 0)
Restore property
(25,000, 15,000)
Don’t, pay penalty
(25,000, 5,000)
 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
46
Penalty clauses
 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!
47
Penalty clauses
 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
48
First Midterm
 Overall very impressive
 Mean 85, median 87
 Not assigning letter grades till end of semester, but…



A-H
to give a rough idea of how you’re doing,
based on distribution of scores on first midterm,
80-90 roughly a B, 65-75 roughly a C
I-P
Q-Z
49
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