UNIVERSITY OF CHICAGO LAW SCHOOL
LAW AND ECONOMICS WORKSHOP
The Death of Caveat Emptor
Gerrit De Geest
Washington University School of Law
Tuesday, February 18th, 2014
Seminar Room F—3:30 P.M.
The Death of Caveat Emptor
Preliminary draft
Gerrit De Geest *
Abstract
The ancient maxim of caveat emptor (“let the buyer beware”) gives sellers a right to misrepresent
anything and no duty to disclose whatsoever. While numerous exceptions have been developed
over time, caveat emptor is still occasionally presented as a general principle in contract law.
Moreover, consumers often have the impression that caveat emptor governs the market, as many
marketing and sales methods are based on exploiting the seller’s superior information in subtle,
but apparently legal ways. So how dead is caveat emptor?
In this paper, I argue that caveat emptor is no longer a fundamental principle in contract law
but rather an exception that is justified in only two narrowly defined cases (the protection of
entrepreneurial information, and the correction of market failures paradoxically caused by too
much information). The principle that best explains the law is that of the least cost information
gatherer (LCIG).
Still, in practice, caveat emptor is more prominent in markets than it should be because courts
do not consistently apply the LCIG principle. Courts err by underestimating which information is
material (an error that is in turn caused by not fully understanding how search processes work in
practice), by underestimating what type of statements effectively mislead buyers, by not
systematically requiring efficient disclosure, or by mechanically applying per se rules (such as the
opinion, value, or puffery rule) that are no more than proxies for other tests. As a result, caveat
emptor is unintentionally re-introduced through the backdoor.
Overall, markets would change fundamentally if the LCIG principle were consistently applied,
as it should be. More specifically, the LCIG principle dictates that sellers (and service providers)
should have a duty to publish their full price lists on the Internet; that it is up to producers (and
not to consumers or consumer organizations) to finance quality tests; that insurers (and the sellers
of related products, such as extended warranties) should reveal the actuarially fair price; that
sellers should sometimes even reveal markups; that salespeople should reveal whether they give
honest or biased advice and be held to fiduciary standards when they pretend to give honest advice;
and that many common marketing and sales methods should become actionable for
misrepresentation.
* Visiting Scholar, Coase-Sandor Institute for Law and Economics, University of Chicago; James Carr
Professor of Law and Director of the Center on Law, Innovation & Economic Growth, Washington
University at St. Louis. E-mail: degeest@wustl.edu. I thank Adam Badawi, Scott Baker, Michael Greenfield,
Christine Vandenabeele, and participants at a workshop at Washington University for comments. Lauren
Abbott, Ethan Hatch, Megan Lasswell, Caleb Shreves, Kevin Simpson, and Sarah Walton provided helpful
research assistance.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
2
Contents
1. INTRODUCTION ........................................................................................................................................... 3 A. THE LEAST-COST-INFORMATION-GATHERER PRINCIPLE AND ITS EXCEPTIONS ... 6 2. EXPLANATION AND ECONOMIC JUSTIFICATION ............................................................................................. 6 2.1. The LCIG principle best explains the law .................................................................................. 7 3. EXCEPTIONAL CONDITIONS UNDER WHICH CAVEAT EMPTOR IS JUSTIFIED .................................................. 8 3.1. Protection of entrepreneurial information ................................................................................. 8 3.2. Other policy reasons why information should not be known by the other party ...................... 10 3.3. Not a true exception but a practical limitation: non-falsifiability ............................................ 10 B. MID-LEVEL PRINCIPLES ............................................................................................................. 12 4. DUTY TO DISCLOSE FOR ABSOLUTE LCIG, NO RIGHT TO MISREPRESENT FOR RELATIVE LCIG..................... 12 5. SEARCH-IN-PRACTICE: MUCH MORE INFORMATION IS MATERIAL THAN QUALITY AND PRICE ....................... 13 6. COMMUNICATION-IN-PRACTICE: MUCH MORE IS MISLEADING THAN JUST LITERALLY FALSE STATEMENTS .. 15 7. EFFICIENT DISCLOSURE: THE LCIG’S DUTY TO DISCLOSE IN THE MOST EFFICIENT WAY .............................. 18 8. UNREASONABLE RELIANCE SHOULD NOT BE A DEFENSE FOR FRAUDULENT MISREPRESENTATION (OR
DELIBERATE PUFFERY) ............................................................................................................................ 19 9. THERE IS NO NEED FOR PER SE RULES SUCH AS THE OPINION RULE, VALUE RULE, OR PUFFERY RULE ............ 20 C. IMPLICATIONS: MARKETING AND SALES METHODS VIOLATING THE LCIG
PRINCIPLE ................................................................................................................................................ 23 10. NO DISCLOSURE BY THE ABSOLUTE LCIG ............................................................................................... 24 10.1. Not financing standardized quality tests ................................................................................ 24 10.2. Not publishing material statistical information on quality obtained as a by-product of doing
business ........................................................................................................................................... 25 10.3. Not revealing the actuarial cost of insurance (and warranty) products ................................. 25 11. NO EFFICIENT DISCLOSURE ...................................................................................................................... 26 11.1. Not publishing full price lists on the Internet (in a standardized form).................................. 26 11.2. Stealth price increases ........................................................................................................... 28 12. MISLEADING ........................................................................................................................................... 28 12.1. Deliberately making products incomparable (concealment).................................................. 28 12.2. Making false or exaggerated differentiation claims ............................................................... 30 12.3. Deliberately setting the price high to make buyer believe the quality is high ........................ 31 13. MISREPRESENTING MATERIAL INFORMATION ........................................................................................... 32 13.1. Misrepresenting the honesty of the advice ............................................................................. 32 13.2. Should marketers disclose the fact that they try to exploit behavioral biases? ...................... 33 13.3. How look-no-further stories affect buyers’ decisions ............................................................. 34 13.4. Misrepresenting markups. Should there be a duty to reveal markups? .................................. 36 13.5. Misrepresenting the seller’s cost structure or motivation ...................................................... 37 13.6. Misrepresenting market prices or competitor prices; price anchoring and reference pricing
(false or non-substantiated claims) ................................................................................................. 37 13.7. Misrepresenting what other customers pay; price discrimination based on search costs ...... 38 14. CONCLUSION .......................................................................................................................................... 38 DE GEEST – THE DEATH OF CAVEAT EMPTOR
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1. Introduction
Caveat emptor is an ancient maxim that tells buyers to beware of sellers.1 The maxim implies
that sellers have no duties to disclose whatsoever and are even entitled to make any
misrepresentation they want; buyers are responsible for collecting all information and are at their
own peril when they rely on false statements. While the principle literally refers to buyers, caveat
emptor is usually interpreted so as to also include caveat venditor (“seller beware”); the idea is then
that all parties are responsible for their own mistakes in arm’s-length negotiations.2
Caveat emptor has no economic justification (except in a few narrowly defined cases, which
I will later discuss). This is obvious when we consider its purest version—which permits even plain
fraud. Suppose I sell you one of my own paintings as an authentic Picasso for $10 million. Under
a pure caveat emptor rule, such a sale would be legal. Indeed, you had to beware of me. It was your
responsibility to check whether I was lying, so it is your own fault if you fell into the trap I set for
you. Plain fraud is of course socially undesirable for many reasons: It leads to allocative
inefficiency (the painting ends up in the hands of someone who would not have bought it
otherwise), distributive distortions (I get $10 million richer and you get $10 million poorer),
wasteful precaution (duplicative production of information), and transaction avoidance (to avoid
being defrauded). But weaker versions of the caveat emptor rule, which permit subtle forms of
fraud, are socially undesirable too. That some fraud is subtle does not mean it is socially harmless
—it leads to the same type of distortions as plain fraud. If sellers do not have to disclose termite
infestations, houses may end up in the hands of buyers who would not have bought them otherwise,
sellers may get wealthier at the expense of some buyers, buyers may order wasteful inspections,
and potential buyers may no longer enter the market.
If caveat emptor has no economic justification, why would legal systems ever use it? Legal
systems may do so for the same reason that they tolerate other forms of socially undesirable
behavior: administrative costs. Correcting all market failures is costly; legal systems with resource
constraints therefore focus only on the most serious failures. Still, the pure version of caveat emptor
is rarely found in legal systems.3 Over the course of the 20th century, as America’s economy became
1
There is discussion on how ancient the maxim really is. See Hamilton, The Ancient Maxim Caveat Emptor,
40 Yale L.J. 1133 (1931) (arguing that the Romans had no law on the matter, so that it is incorrect to state
that a caveat emptor rule applied).
2
There is some terminological confusion on the term caveat venditor. Sometimes the term is used to refer to
a legal regime that always lays the blame on the seller.
3
Even Roman law had some rules on fraud and latent defects. Nor was the doctrine applied in medieval or
early modern times, when courts often stopped the exploitation of asymmetric information through the “just
DE GEEST – THE DEATH OF CAVEAT EMPTOR
4
richer and the capacity of its legal system increased, a long list of exceptions to caveat emptor was
formulated. The requirement of fraudulent misrepresentation was weakened to negligent (and even
innocent) misrepresentation in contract law (and even in tort law in some jurisdictions).
Concealment became a form of fraudulent misrepresentation. Half-truths were no longer tolerated.
Duties to disclose were introduced in contract law, consumer protection law, tort law, corporate
law, and securities regulation.
The principle that now best explains the law is not caveat emptor, but the least-costinformation-gatherer (LCIG) principle. This principle states that information should be produced
and communicated by the party that can do so with the least costs. This can be the buyer; but it is
usually the seller, who may have obtained information as a by-product of owning the product, who
may have more expertise, or who may have economies of scale in the production of information.
Caveat emptor is only justified in two narrowly defined cases: the protection of entrepreneurial
information, and the correction of market failures paradoxically caused by too much information.
If caveat emptor no longer summarizes the law, why is it still occasionally mentioned as a
legal principle by courts and commentators?4 One reason is that the LCIG principle and its
corollaries are insufficiently understood. A superficial look at cases in which the buyer lost may
lead to the wrong conclusion that caveat emptor is still alive. The first goal of this Article will
therefore be to better identify the exceptions and corollaries of the LCIG principle.
But if caveat emptor is no longer law on the books, why do buyers often have the impression
that caveat emptor governs the market? This brings me to the second goal of this Article—
analyzing the relationship between modern marketing/sales methods and the LCIG principle. Many
common marketing and sales methods exploit informational advantages of sellers at the expense
of buyers. But if sellers are the LCIGs, why do courts tolerate those methods? I argue that this is
because courts make errors in the application of the LCIG principle—and marketers and sales
people have learned how to exploit these errors.
The main goal of this paper is to show that, if the LCIG principle were consistently applied,
as it should be, many markets would change significantly. More specifically, the LCIG principle
price” doctrine and guilds punished dishonest sellers. Though courts narrowed the exceptions in the 19th
century, they never applied the caveat emptor doctrine in its pure form. For instance, the landmark decision
of Laidlaw v. Organ (1817) made an exception for “imposition.” Laidlaw v. Organ, 15 U.S. 178 (1817).
4
E.g., Perillo, 6th, p. 304: “In general, caveat emptor remains as a viable doctrine in commercial realty and
transactions between merchants.” “Laidlaw v Organ (...) can be cited for the general rule that in a bargaining
transaction there is generally no duty to disclose information . . . . (p. 302).” Sometimes this is linked to the
related principle that negotiations are assumed to be at arm’s length.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
5
implies that sellers should have a duty to publish prices on the Internet (since price information is
material, sellers are the absolute LCIGs, and publishing on the Internet is the most efficient form
of disclosure). It also implies that it is up to sellers to finance extensive quality tests of their
products—not up to consumers or their organizations, as is now often the case. The LCIG principle
also implies that sellers should reveal statistical data on repair rates, which they receive as a byproduct of doing business; it is inefficient to let consumers produce this information by collecting
experiences on websites such as Amazon. Other implications are that insurers (and the sellers of
related products, such as extended warranties) should reveal the actuarially fair price; that sellers
should sometimes disclose their markups; that the opinion and puffery defenses should be
abolished; and that salespeople should reveal whether they give honest or biased advice and be
held to fiduciary standards when they pretend to give honest advice.
I also argue that many marketing and sales methods, such as price conditioning, potentially
violate the LCIG principle. To the extent that these methods are in tension with the LCIG principle,
they should no longer be tolerated by courts.
This paper contributes to the literature in two ways. First, it identifies the exceptions and
corollaries of the LCIG principle (in Part A) in a more precise way than previous attempts. To do
so, I start from general economic principles that are widely accepted in the law and economics
literature (starting with Kronman, 1978). From these general principles, I derive a number of midlevel principles (in Part B), which are in a sense obvious, but nonetheless not always explicitly
articulated or properly understood. One mid-level principle in particular—that the absolute LCIG
has a duty to disclose, while the relative LCIG has only no right to misrepresent—is novel. The
second (and main) contribution of this paper, however, lies in Part C, in which I identify the logical
implications of these principles. I argue that a consistent application of the LCIG principle would
significantly change the way marketers and salespeople work.
At the outset, I need to make a remark on the limitations of the paper. A first limitation is that
I do not examine which adjustments should be made by courts and which by regulators. While
courts can implement many changes, they are, for instance, not the best institution to define the
standards in which information needs to be published. A second limitation is that I do not discuss
enforcement issues. Caveat emptor can be reintroduced through the backdoor not only by
inconsistently applying the LCIG principle, but also by under-enforcing the rules. Enforcement
levels should be high enough to create sufficient incentives to stick to the rules, and there is some
doubt whether this is the case in consumer markets. Still, this paper will solely focus solely on
substantive rules and set aside enforcement issues.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
A.
6
THE LEAST-COST-INFORMATION-GATHERER PRINCIPLE AND ITS EXCEPTIONS
In this part, I explain the LCIG principle, its economic justification, and its exceptions. My
main point is that fewer exceptions are justifiable than is sometimes believed. More specifically,
entrepreneurial information should be narrowly defined, and non-falsifiability should not be seen
as a real exception (supported by policy grounds) but as a mere practical limitation.
2. Explanation and economic justification
The least-cost-information-gatherer principle holds that the party that can acquire information
at the least cost should acquire this information and reveal it to the other party. The standard
example of Kronman, who first formulated the principle, was the sale of a house infested with
termites. Should the seller (who learned of this infestation as a by-product of living in the house,
for instance by falling through the floor) reveal this information, or should the buyer figure this out
herself, for instance by spending $500 on a termite inspection? Caveat emptor would oblige the
buyer to spend this $500. But this expenditure would be wasteful, because the inspection will only
reveal information that was already known by the seller. The best solution is therefore to oblige
the seller to reveal her information, as it only costs her the time that it takes to utter a few words.
The seller is the least cost information gatherer because she obtained the information at a lower
cost than the buyer ever could—in this case at zero marginal cost, as a by-product of living in the
house.
The economics behind the LCIG principle are simple—even banal. Information is a good that
needs to be produced in society. It is wasteful to let two parties produce exactly the same
information—that would be like one party reinventing hot water. If one of them can obtain the
information more cheaply, that party should obtain it and reveal it to the other.
The LCIG is an application of a more general principle that is best known as the “least cost
avoider” principle in tort law.5 Analytically, the problem is similar to an alternative-care situation
in tort law. In an alternative-care situation, care of one of the parties is sufficient to prevent an
accident. For instance, swimming pool accidents caused by divers hitting swimmers can be
prevented in two ways. One way is to let divers pay more attention when they dive; the other is to
let swimmers swim defensively, always looking around and ready to protect themselves with their
5
Calabresi, 1970, The Costs of Accidents: A Legal and Economic Analysis, New Haven, Yale University
Press.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
7
arms. Which involves the least costs? Clearly the first solution; it requires less effort from divers
to pay more attention than from swimmers to swim defensively. Divers are thus the “least cost
avoiders” of the accidents. They should be held responsible for the accident because they are the
ones who need to be incentivized to be more careful (and as a matter of fact, this is also what courts
do, although not always using this terminology).
The least-cost-information-gatherer principle does not always make the seller responsible for
acquiring information. If the buyer buys the house and later realizes that she does not like the
structure of the house, she cannot hold the seller responsible for that since the buyer is in the best
position to acquire information about her own preferences. But for most aspects of the sales
process, the seller will be in the best position to acquire information, not only because the seller is
the manufacturer or previous owner of the good, but also because the seller is typically the expert
and the buyer is the layman.
The LCIG principle also explains why the caveat emptor doctrine is undesirable. Caveat
emptor always makes the buyer responsible for acquiring the information that is material to the
buyer. But it is not necessarily the buyer who can do this more cheaply. Under a broader definition,
in which the seller is also held responsible for information that is relevant to the seller, caveat
emptor never commands information exchange between parties. Caveat emptor thus forgoes
opportunities for division of labor. This is wasteful.
2.1. The LCIG principle best explains the law
The LCIG principle corresponds not only to economic ideals, it also largely predicts what
courts do. For instance, in most states, sellers of houses need to reveal termite infestations.6 More
generally, there is a duty for sellers to disclose latent defects that even goes back to Roman law.7
The LCIG principle also explains, for instance, why pharmaceutical companies have to reveal
the side effects of the drugs they sell. Those companies are clearly the least cost information
gatherers, as compared to the consumers. They have more expertise, and have economies of scale.
6
Leading cases are Hill v. Jones, 151 Ariz. 81 (Ariz. Ct. App. 1986) and Obde v. Schlemeyer, 56 Wn.2d 449,
450 (Wash. 1960). In Massachusetts an older decision that held the opposite, but it is still considered the
binding precedent. Swinton v. Whitinsville Sav. Bank, 311 Mass. 677 (Mass. 1942). Even in Massachusetts,
health and safety risks related to a house must be disclosed. Cutter v. Hamlen, 147 Mass. 471 (Mass. 1888)
(child of prior tenant died of diphtheria because of defective drains).
7
Perillo, 6th, p. 304. American courts abandoned it in favor of caveat emptor in the nineteenth century, but
it has been resurrected in the twentieth century. Courts have even held that the fact that a house is haunted
by ghosts may need to be disclosed. Stambovsky v. Ackley, 169 A.D.2d 254 (N.Y. App. Div. 1st Dep't 1991).
DE GEEST – THE DEATH OF CAVEAT EMPTOR
8
It would obviously be inefficient to demand that each individual consumer perform those
laboratory tests, or to demand consumers as a group to figure out the side effects by collecting
experiences on websites such as Amazon.com.
The LCIG principle explains many more specific rules in contract law. Parties who have
expertise have increased disclosure duties. Moreover, the condition of “reasonable reliance” is a
way to check the relative information gathering costs of buyers. When courts conclude that there
was no reasonable reliance, they say in essence that the buyer was the LCIG.8
But the LCIG principle also explains numerous other legal rules. It explains why doctors have
to reveal the risks of procedures. It explains why consumers who apply for life insurance have to
honestly reveal their health history, and why there are broad duties of disclosure in suretyship. It
explains why producers (who are obviously in the best position to collect safety information) have
extensive duties to warn. It explains the many statutes and regulations that require disclosure of
information believed to be material to specific parties.9 It also explains what courts really do when
they apply vague rules such as those on puffery, value, and opinion (as we will see in Section 9).
3. Exceptional Conditions Under Which Caveat Emptor is Justified
The LCIG principle is so evident, from an economic point of view, that policy reasons must
be strong in order to set it aside. In this section, I summarize the narrow conditions under which
exceptions are justifiable.
3.1. Protection of entrepreneurial information
The best-known exception to the LCIG principle—and one that was already identified by
Kronman (1978)—is the protection of what could be called “entrepreneurial information.”
Entrepreneurial information is an insight about how specific resources could be used more
productively. It could be, for instance, insight that land could be used for mining valuable minerals
instead of for farming or that a painting is a masterpiece so that it could hang in the Louvre rather
8
Consider the following case. A buyer, who entered into the sheep herding business and wanted to buy land
that was previously not used for sheep, asked the seller (who was a layman with respect to sheep herding)
how many sheep could be put on the land. The buyer later found out that fewer sheep could be put on the
land than the seller had mentioned. The seller’s answer was considered not actionable. This case can easily
be explained on the basis of the LCIG principle: the buyer, not the seller, was the expert. Compare with
Restatement 2nd, §168.
9
E.g., the Securities Act, the Truth-in-Lending Act, the Interstate Land Sales Full Disclosure Act, and the
Truth-in-Negotiation Act.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
9
than in the living room of someone who does not realize its value.
Entrepreneurial information needs to be carefully defined, though. A proper definition lists
three conditions that all need to be fulfilled to justify a protection in violation of the LCIG principle.
The first condition is that the information is costly to produce. Indeed, the economic justification
for the protection is to give incentives to produce the information; if the information is obtained
for free (for instance as a by-product of another activity, such as living in a house), no such
incentives need to be created.
The second condition is that, without the protection, the information could be appropriated by
the other party. Therefore, there is usually no need to protect entrepreneurial insights when they
are related to goods that are owned by the entrepreneur. If I discover that my land contains minerals
or that my painting is a masterpiece, I have no problem. Even if you find out what I know, I will
still be the one who makes the money. There is only a free-rider problem when I possess such
information on goods that are owned by someone else. Suppose that after spending a million dollars
on geological research, I learn that your land contains valuable minerals. If I have to disclose that
information before buying the land, you will acquire it at no cost. You will essentially say, “Thank
you very much for doing this costly research for me for free. Now that I know this, I will sell my
land to someone else for a price that reflects the value of the minerals.”
But there is a third condition that should not be forgotten—that the information should be
socially valuable. Consider a new sales method to mislead consumers. This method may have been
costly to develop (so the first condition is fulfilled). If the method is revealed to the consumer, it
loses its effect and that the “development” costs cannot be recouped (so the second condition is
partly fulfilled). But misleading consumers is not a socially valuable activity (and so the third
condition is not fulfilled). As a matter of fact, if the production of such a method is discouraged,
that is actually a good thing.10
The entrepreneurial information exception is not only an economic ideal but also a rule that
10
Cooter & Ulen (distinguishing between productive versus redistributive information). Note also that one
reason why information rent seekers may easily be confused with entrepreneurs is that both make money by
seeing something that other people didn’t see. An entrepreneur sees new opportunities in the market and
exploits this superior insight to make a profit. In essence, an entrepreneur sees consumers who are willing to
pay a high price for a new product and manufacturers who are able to make that product for a low price. The
entrepreneur brings both together and cashes in on a part of the surplus. This is not so different from a
plumber who charges $29 for a $1 bolt. In a sense, the plumber also sees new opportunity in the market—to
overprice bolts. In a sense, the plumber also brings people together in the market—consumers who are
willing to pay $29 for a bolt and manufacturers who are willing to produce that bolt for $1.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
10
is effectively applied by common law courts.11 Buyers do not have to disclose that the land contains
valuable minerals or oil.
It is important to realize, however, that by protecting entrepreneurial information, a caveat
emptor regime is created.12 Owners of land should now have to beware of buyers, who may have
valuable information that they won’t disclose. Moreover, the entrepreneurial information exception
generates the same waste as other caveat emptor markets: duplicative information may be
produced. Indeed, imagine that before selling, the farmer pays an expert to find whether her land
contains valuable minerals. In this case, information will be produced that has already been
produced. Moreover, since the LCIG does not reveal the information, it is possible that someone
other than the LCIG produces the information. Still, the legal system protects entrepreneurial
information to incentivize its production—even if such protection comes at a cost.
3.2. Other policy reasons why information should not be known by the other party
The protection of entrepreneurial information is not the only policy reason to deviate from the
LCIG principle. There can be other policy reasons why information exchange is undesirable on the
market. At the outset, it should be said that these are not the typical situations because markets
usually function best with full information. Still, there may be markets in which too much
information is the problem. Consider a health insurance market that is so seriously affected by
adverse-selection problems that those who need insurance the most can no longer buy it. In this
case, one way to make it work may be to prevent insurers from knowing certain personal
characteristics of the insured. Therefore, insured parties should have no duty to disclose those
personal characteristics, even if they are the LCIG with respect to this type of information.
3.3. Not a true exception but a practical limitation: non-falsifiability
A statement is non-falsifiable when there is no way for courts to check whether it is true.
Indeed, a misrepresentation is a statement that is not in accord with the facts. If the court cannot
observe the facts, then there is no way to prove misrepresentation.
11
Farnsworth. 2004. Farnsworth on Contracts (3rd ed.), p. 477 (“A purchaser of land […] is not expected to
disclose to the vendor circumstances, such as the presence of valuable minerals that make the property worth
more than the vendor supposes”). The Restatement (Second) of Contracts, which was written before
Kronman’s 1978 article, tries to allow for these exceptions through the vague rule that only duty when
nondisclosure “amounts to a failure to act in good faith and in accordance with reasonable standards of fair
dealing” (which may be the case, for instance, when info acquired on minerals through trespassing).
12
Or, in the previous example, more precisely a caveat venditor regime.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
11
Yet it is important to realize that non-falsifiability is not a deliberate exception to the LCIG
principle, but a practical limitation. To illustrate, consider a negotiation à la Myerson and
Satterthwaite.13 Suppose that you are interested in buying a painting that is hanging in my living
room. You love the painting more than I do; your true willingness-to-pay is $10,000 while my true
willingness-to-accept is only $5,000. So in an ideal world, the painting will be transferred to you
for a price between $5,000 and $10,000. But the problem is that I don’t know that your true
willingness-to-pay is $10,000 and you don’t know that my true willingness-to-accept is $5,000. So
in order to increase the high price, I may pretend that I like the painting much more than I do. In
essence, I am misrepresenting my willingness-to-accept. And you may in turn “lowball” by acting
as if you are not that interested. The danger of this strategic behavior is that a Pareto-superior
transfer (that makes both of us better off) may not take place. We may come to the incorrect
conclusion that a sale cannot make us better off. So why don’t I honestly reveal my true
willingness-to-pay? Because if you don’t do the same, that would undermine my negotiation
position. I am not only interested in a deal, but also in a deal in which I get most of the surplus.14
The solution, in theory, is simple: force both parties to honestly reveal their true valuation to
a judge and let the judge determine a price.15 In that case, there would never be an inefficient
outcome in which the sale does not go through. But in reality, there is simply no way to force
parties to be honest. Statements on purely subjective valuations are intrinsically non-falsifiable.
We don’t have machines that read minds. Legal systems have inherent limitations of a practical
nature.
But non-falsifiability should not be considered a true defense. The only justification for caveat
emptor here is the practical limitations of legal system. If those limitations no longer exist, there is
no reason to apply caveat emptor. Suppose that the owner of an old mom-and-pop shop tells his
customers that, in his opinion, product A is better than product B. In reality, however, he does not
believe that A is better than B, but he only recommends A because it has a higher markup. In this
case, the misrepresentation of the “opinion” might be non-falsifiable. After all, what the storeowner
truly believes is all in his head and there is no technology to directly read his mind. But now
consider a large electronics store that trains its salespeople to convince consumers to buy the
13
Myerson and Satterthwaite. 1983. "Efficient Mechanisms for Bilateral Trading". 29 Journal of Economic
Theory, 265–281.
14
The problem is essentially one of a trade-off between efficiency and information rents, as shown by
Myerson & Satterthwaite.
15
In technical terms, the problem could easily be solved if the “revelation principle” could be applied.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
12
inferior but higher-markup product A. Here, the evidence of the misrepresentation is no longer in
an individual’s head, but in written scripts. It is no longer impossible to prove the
misrepresentation.
Courts should not err to conclude that parties have the right to make certain misrepresentations
because they were non-falsifiable in the past.16 If those statements have become falsifiable in the
present, there is no reason to keep a caveat emptor regime alive.
B.
MID-LEVEL PRINCIPLES
4. Duty to disclose for absolute LCIG, no right to misrepresent for relative LCIG
The principle of LCIG applies both to the duty to disclose and duty not to misrepresent. If I
sell my house, I need to disclose the termite infestation to the buyer. If my neighbor’s house is for
sale at the same time, so that we compete in the same market, I do not have to reveal all the positive
characteristics I happen to know about that house—it is my neighbor’s responsibility to bring that
information on the market and the buyer’s responsibility to compare the two offers. But still, I may
not falsely state that my neighbor’s house has been infested with termites when I know it has never
been. So while I have no duty to disclose what I know about competing products, I have no right
to make misrepresentations about competing products either. If I were to make such
misrepresentations, it would be reasonable for the buyer to rely on them. After all, I am in a better
position to learn of such facts since I live next to that house, while the buyer does not. I am the
LCIG compared to him. And this principle applies not only to intentional but also to negligent
misrepresentation. If I tell you that the jewels I sell are 24-carat gold (which I truly believe is
correct) while in reality they are only 14-carat gold, you may sue me for negligent
misrepresentation. Buyers can reasonably rely on my statements. It is my responsibility to check
the accuracy of such statements; after all, I can check this more cheaply than the buyers because I
have more expertise, and I have informational economies of scale since I sell jewels to many
customers. Therefore, I am the LCIG.
If the LCIG principle explains both disclosure duties and misrepresentation claims, the
question is why both do not fully overlap. Why are there statements that you do not have to make
16
Courts may do so by mechanically applying the opinion rule.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
13
though if you make them you have to be precise? If you are really the LCIG for certain types of
information, why don’t you have to disclose this information in the first place, just as the owner of
a house that is infested with termites must?
This question has not been satisfactorily answered in the literature so far. The conditions for
a duty to disclose are not well identified.17
To understand when the LCIG should have a duty to disclose, I suggest differentiating what I
will call the absolute LCIG and the relative LCIG. The absolute LCIG is the party that is best
placed in the entire society to produce certain information. For instance, the owner of a house is
the absolute LCIG with respect to information that is obtained as a by-product of living in the
house. Apple is the absolute LCIG with respect to technical specifications and prices of Apple
products. The relative LCIG is not in the best position of the entire society, but is still in a better
position than the other contracting party. For instance, I am not in the best position to know
information about my neighbor’s house (my neighbor is) but I am in a better position than a
prospective buyer who lives 100 miles away. Apple is not the absolute LCIG with respect to
information on Google products (Google is), but if Apple salespeople give inaccurate information
about Google products, I may rely on it because the salespeople are the relative LCIGs. After all,
selling devices is their job, so they are in a better position to acquire information about Google
products than I am. Therefore, if they make a representation about Google products, I may
reasonably rely on it.18
5. Search-in-practice: Much more information is material than quality and price
Materiality means that the information is important enough to be produced or communicated.
Materiality is a condition that makes economic sense, both with respect to disclosure duties and
with respect to identifying negligent misrepresentation.19 With respect to disclosure duties,
17
The Restatement 2nd of Contracts §161(b) states (in line with the termite cases) that non-disclosure of a
fact is equivalent to an assertion that the fact does not exists if “he knows that disclosure of the fact would
correct a mistake of the other part as to a basic assumption on which the party is making the contract.” But
this seems to suggest that non-disclosure claims and misrepresentation claims fully overlap.
18
Another category of statements that do not need to be disclosed but may not be misrepresented are
statements that fall short of meeting the materiality criterion. In other words, they are not important enough
to consumers to bring their attention to it, but if their attention is brought to it, the information has to be
accurate.
19
There is doctrinal confusion on whether materiality is also a condition for fraudulent misrepresentation.
Restatement, Second, §§162 and 164 and comment c to §162 do not require proof of materiality in case of
fraud. But see Blum, 2013, Contracts (6th ed.), p. 437: “In light of this confusion in the doctrine, the best
approach is to recognize that materiality is commonly identified as an element of fraud, but that some courts,
DE GEEST – THE DEATH OF CAVEAT EMPTOR
14
materiality implies that information should be produced and disclosed only when its information
cost is lower than its value to the buyer.20 With respect to misrepresentation, materiality means that
statements should be double-checked by their maker only when the cost of double-checking is
lower than the value of more accurate statements.21
It is important to see, though, that what is material depends on the type of search process.
Consider an ideal search process: buyers instantly see all products that are on the market, their
features, their objectively tested quality, and their final prices. In such a search process, relatively
few other types of information are relevant outside price and quality. For instance, it does not
matter who else is using the product. Such information can serve as a quality signal in the absence
of better information (“the product can’t be bad if so many other people are using it”) but when
objective quality information is available, noisy signals lose their effect. Similarly, information on
previous prices or stories about why the seller is able to offer a particular product for a particular
price are not relevant. Moreover, misleading statements about competing products are less likely
to influence buyers.
But now let us consider a different, and possibly more realistic, search process—the sequential
search model of George Stigler.22 Here, the buyer does not simultaneously see all products, but has
to inspect one product at a time, incurring a search cost for each additional product she investigates.
following the Restatement, Second, formulation, underplay it or do not articulate it as a requirement.
However, even in those cases, some attention is commonly given to materiality in the opinion, either in the
overall analysis or in addressing the question of justifiable inducement.”
20
Value, in this context, when it can influence the recipient’s decision to contract; it therefore depends on
the likelihood of effective reliance. Cf. Farnsworth on reliance (p. 482): “as long as the misrepresentation
substantially contributed to the party’s decision. If the misrepresentation was material, it is assumed that this
is the case in the absence of a contrary showing.” Effective reliance is often mentioned as a separate condition
(Was the buyer effectively misled? Did the misrepresentation effectively influence the buying decision?).
However, reliance then becomes synonymous with causation—the private-law principle that the plaintiff
should prove that the bad behavior of the defendant caused the harm. More specifically, courts want to check
whether the misrepresentation really caused the buying decision and is not a cheap excuse afterwards. Of
course, if courts would systematically err in favor of the seller with respect to effective reliance, they could
once again re-introduce caveat emptor through the backdoor.
Note that the economic justification for the materiality condition is similar to the economic justification of
negligence in tort law. Precaution should be taken only when the cost of precaution is lower than the benefits
of precaution in terms of reduced expected accident costs. (Cf. the Learned Hand formula).
21
Materiality is not only a condition for misrepresentation under contract law. It is also the principle behind
many regulations. As a matter of fact, many regulations specify which information is material (and therefore
needs to be disclosed) in specific sectors. For instance, FDA food-labeling rules require a listing of the
ingredients considered relevant enough by a sufficient number of people to be worth including on the label.
Another example is the FTC regulation that creates a duty to reveal washing instructions of textile (this is
indeed something that is important enough to be revealed).
22
Stigler, 1961. "The economics of information". 69 Journal of Political Economy, 213–225.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
15
So, after she has learned the quality and price of the first product, she can either stop looking and
buy that product or she can spend time and money to inspect a second product. After she has
investigated the second product, she can either decide to buy one of the two products that have
been inspected so far or move to another round in which she inspects a third product. This process
goes on until the buyer decides to look no further and buy one of the inspected products.
In this sequential search model, much more information becomes material. As a matter of fact,
a part of the energy of salespeople might then go to convincing buyers to stop searching. One way
to do so is to come up with look-no-further stories. For instance, sellers may try to convince a
buyer that they are the only ones who sell certain products (even if that is not the case); if the buyer
believes this then she may stop looking. Or the sellers may try to convince the buyer that the
markup is exceptionally low (even if the markup is relatively high); if the buyer believes the
markup is low, she may be convinced that looking further is unlikely to lead to an even lower price.
Note that there is no absolute principle in the law that forbids courts to consider more realistic
search processes. As a matter of fact, many Federal Trade Commission guidelines seem to assume
such search processes. For instance, it is considered a deceptive practice to misrepresent previous
prices, future prices, normal prices, or prices of other products of the same seller.23 Moreover, the
honesty of the advice, clinical tests, expertise, or endorsement needs to be revealed.24
When courts make errors in defining materiality, they unintentionally reinstate caveat emptor.
To see how this may happen, consider the following hypothetical. Imagine that courts mistakenly
believed the fact that the true identity of the painter is not material in the sale of paintings. In other
words, imagine that courts believed that it does not matter enough for the buyer whether a painting
was painted by Picasso to justify the ten seconds that it takes to reveal this information. If that were
truly the case, buyers would have to beware of false masterpieces. The market for masterpieces
would be governed by caveat emptor—not in theory, but in practice.
6. Communication-in-practice: Much more is misleading than just literally false statements
That representations should not be misleading is again an obvious corollary of the LCIG
principle. It is not sufficient for the LCIG to reveal the information. The information should be
23
For instance, the term “economy size” packet is only permitted when the price per quantity is lower than
is the case with all other packages of the same product line.
24
Ref. E.g., settlement between the FTC and Skechers, Inc. Skechers, Inc. v. FTC
(http://ftc.gov/os/caselist/1023069/index.shtm). See also the recent FTC policy statement on celebrity
endorsements (celebrities cannot falsely state they use a product).
DE GEEST – THE DEATH OF CAVEAT EMPTOR
16
communicated in a non-negligent, non-misleading way. To illustrate, just imagine that it would be
fine for pharmaceutical companies to reveal the side effects of their drugs in a way that few people
would understand. Or imagine that it would be fine for me to reveal that my painting is not a Picasso
in such an incomprehensible way that most people would interpret it as saying that Picasso is the
painter.25
Once again, the main insight to be conveyed here is that, if courts err with respect to what
really misleads people, they re-introduce caveat emptor through the backdoor. Errors lead to
markets in which patients do not get to know the side effects of drugs or in which interested buyers
of paintings do not get to know which paintings are original Picassos and which ones are
counterfeits.
A naïve (and old) way of examining whether a statement is misleading is to analyze its literal
meaning. If the literal meaning is false, the statement is a misrepresentation. If the literal meaning
is in accord with the facts, there is no misrepresentation. But courts have experienced (and language
experts have confirmed) that communication processes among human beings work differently. To
understand what someone says, one should not only consider the words (or text) but also the
context. The reason is that literally expressing a thought typically requires an enormous amount of
words. To economize one words, we say relatively few words and trust that the receiver will
understand what we mean by also considering the context. Suppose, for instance, that during dinner
I say to you, “Could you give me the ketchup?” There are billions of bottles of ketchup on this
planet, and I do not specify which one you should give me. If I mean Heinz ketchup, I do not say
which of the 57 varieties I want.26 Moreover, I do not specify the time, the room, the street, the
city, the country, and the planet where I expect the ketchup to be delivered. And still, you
understand what I mean by considering the context. We are eating hamburgers in a specific place
and you see that there is only one bottle of ketchup on the table.
To see how messages are interpreted, one should consider not only the text and the context,
but also the social norms of conversations. These norms help us understand which general
implications are typically derived from the uttering of certain words. They have been studied by
language philosophers such as Grice and Searle.
One of the findings of this literature is that when someone gives information, we assume that
25
I could do so, for instance, by saying, “It is impossible to deny that Picasso is not the painter.” Literally, I
say that Picasso is not the painter, but many people will think I am saying the opposite.
26
To be true, "57 Varieties" was a slogan chosen at random by Heinz's founder; the company made a lot of
sauces, of which ketchup was only one. But you get the point.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
17
she has some form of substantiation.27 Suppose I tell you there is a Walgreens on a specific street.
You go there and find out that my statement was false. It turns out that I absolutely did not know
whether there was a Walgreens there, but I just said something at random. In this case, I violate
social norms. When I say there is a Walgreens, you assume that I have some form of substantiation.
Maybe I have been there or maybe I have heard someone say it. But I should have some argument
to base my statement on.
So when a tire manufacturer says that it makes the best tires in the world, people assume that
the manufacturer has substantiation.28 Maybe the tires came out as the best in a test by a consumer
organization. Maybe the manufacturer performed its own tests. Maybe there is a theoretical
argument why a certain design is supposed to work better. But there should be at least something.
If the statement was made without substantiation, the statement was misleading.
Another finding of that literature (and of Searle in particular) is that no remark should be made
without remarkability.29 If I say that my neighbor was sober last Tuesday, I suggest that this is not
always the case. I do not literally say that my neighbor is sometimes drunken. But if there is nothing
remarkable about the fact that he was sober on Tuesday, I should not make that remark.
Communication experts have also found that no communication is sometimes a form of
communication. In other words, saying nothing is saying something. Suppose I sell my used car
but do not say anything about its quality. Depending on the context, you will make inferences about
the quality. Maybe you will think that, because I say nothing, the quality is average (applying the
no-remark-without-remarkability principle). Maybe you will think that, because I say nothing, the
quality is perfect. Or maybe you will think that, because I say nothing, my car is of the lowest
possible quality.30
Modern law largely applies these principles. Common law courts do so by applying the
objective theory. It is the perceived meaning, rather than the literal meaning or the original intent,
that counts.31 Courts hold misleading non-verbal communication actionable by considering
27
Paul Grice, Logic and Conversation, reprinted in Stud-ies in the Way of Words, 26–27 (Paul Grice ed.,
1989) (“Do not say that for which you lack adequate evidence”).
28
That is, buyers assume the manufacturer has substantiation unless they believe all manufacturers just puff.
But if buyers attach zero value to the manufacturer’s statements, making such statements becomes socially
wasteful.
29
Searle. 1979. Expression and Meaning (Cambridge: Cambridge University Press).
30
This may be the case when you believe that markets always “unravel” as predicted in some economic
models.
31
Somewhat relatedly, there is a common law interpretation rule that gives preference to the most common
definition of a term. Some FTC regulations define weight, and terms such as “wool,” “gold=24 karat
throughout,” and even “economy size” (which may only be used when a package is cheaper per quantity
DE GEEST – THE DEATH OF CAVEAT EMPTOR
18
concealment as a form of (fraudulent) misrepresentation. They do not tolerate half-truths. The UCC
applies the saying-nothing-is-saying-something principle by writing implied warranties (of
merchantability) into sales contracts. Relatedly, common law courts create a duty to disclose when
“one learns that one has created a false impression.”32 In consumer law, the duty to substantiate
seems to be a generally accepted principle.33
Still, as we will see in Part C, courts often incorrectly apply these principles, thereby
unintentionally creating caveat emptor markets.
7. Efficient disclosure: The LCIG’s duty to disclose in the most efficient way
The principle of efficient disclosure holds, as the name suggests, that whenever information
needs to be disclosed it needs to be disclosed in the most efficient form. For instance, when the
sellers of a house must disclose the termite infestation, they should do this in a conspicuous way,
for instance by explicitly telling potential buyers—not, for instance, by writing it on a small PostIt card stuck on the back of a cabinet, or by burying this information in footnote 29 at page 17 of a
30-page document.
The principle is evident, important, and easily overlooked. The principle is evident because it
is a necessary condition for the LCIG principle to work. Indeed, if the LCIG has to disclose
information, we would undermine the principle if we allowed her to do so in an inefficient way
(making it artificially costly for buyers to find or understand the information). Just imagine if it
were OK for pharmaceutical companies to publish the side effects of their drugs only on a
whiteboard at their head offices ….
The principle is important because, without efficient disclosure, there may be no information
exchange in practice. And in that case, caveat emptor is re-introduced through the backdoor.
Indeed, if sellers can hide such communications like Easter eggs, buyers need to beware of sellers.
Watch out if you buy a house—the seller may be trying to fool you, and it is all legal as long as
she formally discloses the information in some (hard to find) way.
This principle is not expressly articulated in textbooks, but it is implicit in many court
decisions and regulatory norms. For instance, FTC regulations require washing instructions to be
attached to the textile in the form of a standardized label. Relatedly, the UCC §2-316 requires
than all other packages of the same product line.
32
Farnsworth, p.475.
33
National Consumer Law Center. 2013. Unfair and Deceptive Acts and Practices, §5.2.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
19
warranty disclaimers to be made in a conspicuous way.
Manifest defects (such as broken windows) do not have to be revealed, and that makes sense:
the most efficient form of disclosure here is letting the buyer take a look. The buyer will discover
the information anyway, so that it would be a waste of transaction costs to repeat what the buyer
already knows or will know.
8. Unreasonable reliance should not be a defense for fraudulent misrepresentation (or
deliberate puffery)
We have seen that the requirement of “reasonable reliance” is best seen as a proxy for the
LCIG principle. Buyers rely unreasonably on sellers’ statements when the buyers themselves have
more expertise or better access to information. A special case, however, is the one in which sellers
deliberately try to mislead buyers and buyers naively fail to check those misleading statements. In
such a case, should the seller be blamed for trying to mislead or the buyer for failing to check?
Who is the LCIG in this case? Clearly the sellers: they know best which statements are
misleading, and are therefore the ones who should prevent the misleading. Moreover, intentional
fraud is an investment in lying. Therefore, it does not—strictly speaking—cost the sellers anything
to stop misleading; it costs them money to keep misleading. Another way to see that requiring
reasonable reliance does not lead to optimal outcomes is to consider the equilibria that are reached
when buyers always double check all the seller’s statements. In this case, sellers may no longer try
to mislead them (because they realize they will be unsuccessful), but buyers are still doublechecking all the seller’s statements. If the sellers are held responsible, they no longer try to mislead
and buyers do not have to double-check. So holding only the sellers responsible is clearly the
optimal solution.
Yet, courts occasionally blame buyers for not checking intentional misrepresentations. In
Williams v. Rank & Son Buick, a Chrysler was sold without air-conditioning, though the car dealer
had assured the buyer that there was air-conditioning. However, the buyer’s reliance was not
reasonable in the eyes of the court, because the buyer had an opportunity to test the car.34 In a
recent case, law students sued their own law school (the New York Law School), claiming they
had been misled by its inflated employment and salary statistics (according to which 92.6% of all
2008 graduates had a job within nine months of graduation, and 25% of them made at least
34
Williams v. Rank & Son Buick, Inc., 170 N.W.2d 807 (Wis.1969).
DE GEEST – THE DEATH OF CAVEAT EMPTOR
20
$160,000). The students lost the case. The judge ruled that no reasonable consumer would have
believed such numbers.35
Why do courts make this error? One explanation is that they mistakenly apply the logic behind
the rules on manifest defects.36 If I sell a home with broken windows, I do not have to explicitly
mention that the windows are broken when the potential buyer can inspect the house. The reason
that I do not have to explicitly reveal this is that there is no need to do so: the buyer will notice it
anyhow. As a matter of fact, explicitly revealing what the buyer already knows or will know is a
waste of time. Of course, there may be an extremely small number of buyers who do not notice
what everyone else notices. Since it would be wasteful to require me to reveal something that is
wasteful in 99.9% of the cases, the courts introduced a duty to investigate obvious facts.37 But some
courts have erroneously extended that to cases in which sellers deliberately set a trap for buyers.
Still, the vast majority of common law courts do not make this error. There is a Vermont
precedent going back to 1869 in which the court stated that “the law will afford relief even to the
simple and credulous who have been duped by art and falsehood.”38 Another nineteenth-century
Vermont court said it in even more colorful words: “no rogue should enjoy his ill-gotten plunder
for the simple reason that his victim is by chance a fool.”39 The principle that one cannot blame a
victim for falling into a trap that was set for her is confirmed in twentieth-century case law, for
instance by a Minnesota court that explained that “one who deceives another to his prejudice ought
not be heard to say in defense that the other party was negligent in taking him at his word.”40
9. There is no need for per se rules such as the opinion rule, value rule, or puffery rule
Treatises and textbooks usually mention opinion statements, value statements, and puffery as
35
Gomez-Jimenez v. New York Law School, No. 65226/11 (NY Sup. Ct. Mar. 21, 2012). Technically, the
judge concluded that there was no ‘reasonable reliance.’
36
See also Farnsworth p. 487 on justified reliance: “Thus the recipient may be barred from avoiding the
contract if the misrepresentation was obviously false or if it could not be expected to be taken seriously.”
37
Perillo, J.M. 2009. Calamari and Perillo on Contracts, 6th ed., 294–295.
38
Kendall v. Wilson, 41 Vt. 567, 571 (1869).
39
Chamberlin v. Fuller, 59 Vt. 247, 9A. 832, 836 (1887).
40
Spiess v. Brandt, 230 Minn. 246, 41 N.W.2d 561 (1950). See also Perillo (6th, p. 295): “As Vermont went,
so has gone much of the nation. It is the exceptional case today where, especially in the face of an intentional
misrepresentation, relief be denied on the ground of the undue credulity or negligence of the defrauded party
....”); Farnsworth p. 487, “Courts are, however, particularly indulgent if the recipient is weak or credulous,
even if the falsity of the representation would be obvious to a normal person .… Courts incline to condemn
the maker’s misrepresentation rather than the victim’s credulity.”)
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21
exceptions to the misrepresentation rule.41 Statements are said to be non-actionable when they refer
to opinion or value, or when they are mere puffery.
It is important to see, however, that these rules are proxies for something else, so that there is
no reason to keep them alive as independent per se rules. The disadvantage of using proxies rather
than the real criteria is that more errors are made since proxies are imperfect. As we will see in Part
C, such errors may lead to re-introducing caveat emptor through the backdoor.
Consider the distinction that courts have traditionally made between the statement of facts and
of opinions. Statements of fact can lead to misrepresentation claims, but statements of opinion are
not considered actionable.
What is the problem with the opinion rule? First, opinion is notoriously hard to define. At a
philosophical level, there is no difference between an opinion and a statement of fact. Einstein’s
famous formula E=mc2 seems to describe facts, but it is no more than a hypothesis, or an opinion
of an expert on what the facts are. Moreover, a statement of an opinion is a statement of the fact
that the person holds that opinion. In addition, numerous exceptions have been carved out over
time into the opinion rule, which suggests once more that there is nothing intrinsically desirable
about this rule, but that it is a proxy for something else.
Sometimes, the opinion rule is a proxy for non-falsifiability. In the previously given example
of the mom-and-pop store owner who falsely said that he believed product A to be superior, the
misrepresentation was non-falsifiable because all evidence was in the head of one individual.
Saying “it is an opinion” is then just another way of saying “let’s not waste money; this claim can
never be proven in court.”
In other cases, the opinion rule is a proxy for the LCIG test. If I tell a prospective buyer that
the market price of my land will rise sharply in the next decade, courts will hold that this statement
was no more than an opinion. If the market price does not increase, the buyer can’t sue me. But the
real reasoning behind the “opinion rule” is that I have no better information on future land prices
than the buyer. The buyer cannot rely on my statement because he is in an equally good (or bad)
41
Restatement 2nd, §168 (under heading reliance: Misrepresentations of fact render a contract voidable;
erroneous statements of opinion do not. Check). Michael M. Greenfield, Consumer Transactions 7
(Foundation Press) (5th ed. 2009) (listing the requirement that the representation must be related to a present
fact as one of the 9 conditions for fraudulent misrepresentation.) See also U.C.C. § 2-313(2): “an affirmation
merely of the value of the goods, or a statement purporting to be merely the seller’s opinion or commendation
of the goods does not create a warranty.” But note the qualifying term “merely”; moreover, the comments to
the Code state that some opinion statements should be treated as warranties.
DE GEEST – THE DEATH OF CAVEAT EMPTOR
22
position to predict prices. I can’t be sued because I am not the LCIG.42
That the opinion rule is often a proxy for the LCIG test becomes even more apparent when
we consider its exceptions. One exception is that a buyer may rely on an opinion when the other
party has special expertise.43 In that case, the other party is clearly the LCIG. Another exception is
when the opinion comes from someone who is in a relationship of trust or confidence.44 Here, a
promise was made to give unbiased advice on which the other party could rely. This division of
labor suggests that the opinion-giver was in a better place to form an opinion, or in other words,
that she was the LCIG.
True, when the opinion is a purely normative statement, there is an intrinsic non-falsifiability.
Indeed, since Kant and Hume, we know that normative statements cannot be checked empirically.
So if I say “people should not steal since theft is immoral” there is no way to falsify this statement,
since I describe an ideal world, not the existing world. So when car dealers say “this is the best car
on the planet,” they seem to have found a philosophical crack in the law because “best” is a
normative judgment, not a fact. But never underestimate philosophy! Philosophically, a statement
like “this is the best car on the planet,” is a combination of a norm (for instance, “fuel economy is
the most important criterion for being a good car”) and a factual statement (for instance, “this car
has a better mileage per gallon than all other cars”). The substantiation principle implies that car
dealers who make such a statement have at least a norm in mind plus some factual evidence. Courts
rightly hold that an “opinion” can be a misrepresentation when it is based on false factual
statements.45
Similarly, when courts say that misrepresentation as to the value of an object is not actionable,
they use this as a proxy for either non-falsifiability or LCIG. This becomes clear once again when
we consider the exceptions. In Sunderhaus, a court held that a jeweler could not misrepresent value
42
Cf. Kent, 1827, Commentaries on American Law. (“Every person reposes at his peril in the opinion of
others, when he has equal opportunity to form and exercise his own judgment.”)
43
Cf. Farnsworth p. 491: “Another exception covers the case in which the recipient reasonably believes that,
as compared with the recipient, the person whose opinion is asserted has special knowledge, skill, judgment,
or objectivity with respect to the subject of the opinion. And another exception covers the case in which the
recipient is for some special reason particularly susceptible to a misrepresentation of the sort involved.”
44
Cf. Farnsworth p. 491: “One exception covers the case in which the maker stands in such a relation of trust
and confidence whether the maker is strictly speaking a fiduciary or not, to the person whose opinion is
asserted that the recipient is justified in relying on the opinion” (citing Hassman v. First State Bank, 183
Minn. 453, 236 N. W. 921 (1931)).
45
E.g., Wiseman v. Wolfe’s Terre Haute Auto Auction, Inc. Wiseman v. Wolfe’s Terre Haute Auto Auction,
Inc., 459 N.E.2d 736, 737–38 (Ind. Ct. App. 1984) (seller’s repeated statement that truck was “road ready”
was considered an express warranty).
DE GEEST – THE DEATH OF CAVEAT EMPTOR
23
of a diamond.46 The jeweler was clearly the LCIG here.
“Puffery” is also a proxy for something else. Puffery is typically defined as exaggerated
statements that are common in the marketplace and that no reasonable buyer would believe.47 When
courts say that a statement is non-actionable puffery, they can mean one of several things. First,
they may mean that the seller was making a joke, and that the buyer was one of the few who did
not understand the joke. In this case, they apply the more general rule that those who communicate
should take into account how the statement is likely to be perceived by a significant minority;
occasional fools can be disregarded (as the ignorant-consumer standard is neither applied nor
economically justifiable). Second, they may mean that they do not believe that the buyer effectively
relied on that statement. In that case, the puffery rule is a way to prevent lost time trying to disprove
what looks obvious. Third, puffery may mean that a purely normative statement that is intrinsically
non-falsifiable is, in addition, so vague that nobody expects substantiation. Fourth, puffery can
mean that most other sellers also mislead buyers, but in that case, there is no justification for
granting immunity.
C.
IMPLICATIONS: MARKETING AND SALES METHODS VIOLATING THE LCIG
PRINCIPLE
In this part, I discuss practical implications of the general and mid-level principles I have discussed.
My goal is to show that many common sales practices violate the LCIG principles and its
corollaries. My main point is that the only reason why these practices currently fall through the
cracks of the legal system is that courts err in the application of the LCIG principle and its
corollaries. I discuss errors applying the principle that the absolute LCIG should have a duty to
disclose (section 10), errors applying the principle of efficient disclosure (section 11), errors
applying the materiality requirement (section 12), and errors in the judgment of what is misleading
(section 13).
46
47
Sunderhaus v. Perel & Lowenstein, 388 S.W.2d 140 (Tenn. 1965).
See Preston. 1996. The Great American Blow-Up: Puffery in Advertising and Selling.
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10. No disclosure by the absolute LCIG
10.1. Not financing standardized quality tests
When a new product is placed on the market, potential buyers need information in order to
compare the product with competing products. For instance, if a new type of vacuum cleaner is
offered, potential buyers may want to know how effective this vacuum is on carpet and hardwood
floors, how noisy it is, how much energy it uses, how heavy it is, and how durable it likely is.
Without this information, consumers cannot make rational decisions. But who should produce it:
the seller or the buyer?
Sellers are clearly the least cost information gatherers, because they have not only more
expertise but also economies of scale. Sellers are even the absolute LCIG for information on the
quality of their own goods, which means that sellers should have a duty to disclose (rather than just
no right to misrepresent). Courts, however, usually do not give them extensive duties to produce
and disclose quality information.48 In practice, buyers are therefore the ones who are held
responsible for judging the quality of the products that are offered on the market. Buyers do so by
inspecting the products in the store, by asking neighbors and friends, by sharing their experiences
on websites, or by buying issues of Consumer Reports.
While this may be seen as a “normal” way of information collection, it violates the principle
of the LCIG. Buyers are not the LCIG. They not only lack expertise, but information on products
is also a public good for them, so that the information is usually under-provided.
While sellers should finance (if possible, standardized) quality tests of their products, this does
not mean that they need to produce an infinite amount of information. Only material information
needs to be produced and disclosed. Whether information is material (that is, whether its benefits
outweigh its costs) is a factual issue. But for mass-produced goods, the materiality requirement
tends to be easily required because of the economies of scale in the information production.
Note that mandatory standardized testing for products is nothing new. It already exists for
many products. Car manufacturers are required to measure the miles-per-gallon of each car model,
airplane manufacturers must reveal safety information, pharmaceutical companies must conduct
rigorous scientific tests, and food producers are required to conduct standardized nutritional tests
on their products. In additions, consumer law requires sellers to perform state-of-the-art tests before
they can claim that something is “clinically” or “scientifically” proven. Sure, the legal system has
48
Unraveling, though predicted in some models, often does not take place in markets.
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to make sure not to overshoot by demanding useless, expensive tests, but that holds for all legal
rules (e.g., tort law should not overshoot by demanding excessive precaution from businesses), and
this overshooting risk is in itself no reason to abolish the law.
10.2. Not publishing material statistical information on quality obtained as a by-product of doing
business
Buyers need information on quality and pricing, but that is especially hard when the
information is of a statistical nature. How often does a particular car model break down? How
many people suffer a stroke as a side effect of a certain drug? How often does a brand of dishwasher
need to be repaired? This is a matter of probabilities. But if you want information on the true quality
or durability of a product, you need this type of information.
Statistical information is not only required to know the true quality of a product but also to
know its true price. How expensive is a plumber? That varies from case to case, depending on
which spare parts are needed and how much the plumber overprices each spare part. How
expensive is a car, if you take into account that the car itself is competitively priced and the spare
parts are overpriced? That depends on how often certain repairs are needed, and the price of the
repair itself in each of those cases. So if you really want to compare the true price of a car, you
need loads of statistical information. And statistical information is obviously required if you want
to know how much most other consumers are paying for the same good.
That sellers are the LCIG of probability information is obvious, not only because it is easier
for them to collect such information but also because they usually already have this information as
a by-product of selling goods. They know how many of their products are returned for repair, or
how many spare components are ordered by repair shops. They know how often a product is sold.
Consumer organizations may try to reverse-engineer what sellers already know by organizing
surveys among large numbers of consumers, but such surveys not only draw a less precise picture,
but they are also intrinsically wasteful because they reproduce information that is already known
by the seller. Of course, sellers may not always have incentives to reveal this information, and so
the legal system must step in.
10.3. Not revealing the actuarial cost of insurance (and warranty) products
The actuarial cost (or “actuarially fair price”) is the part of the insurance premium that will
statistically be paid out to customers. For instance, if insurance costs $100, $70 of which goes go
to the paying out of claims, and $30 of which goes to administrative costs and profits, then the
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actuarial cost is $70. This is an essential piece of information, because one quality element that can
differ among insurance companies is the ease with which they pay out (or to frame it differently,
the degree of their insurer opportunism afterward). Moreover, whether buying insurance is rational
depends on how much the retail price exceeds the actuarially fair price. In the absence of
transaction costs and profits, buying insurance for even low amounts is rational when parties are
risk-averse. But when there are positive transaction costs and profits, insurance typically only
becomes rational for larger risks. The exact point at which insurance becomes rational, however,
depends on the magnitude of the transaction costs and profits. Therefore, the actuarially fair price
is information that needs to be known before a rational decision to insure can be made. (And this
also applies to products that have an insurance function but that are not legally insurance contracts,
such as warranties.)
Who is the LCIG of this information? It is obviously the insurer, not the insured. While the
insured may vaguely know his “type” (for instance, whether he takes relatively more risks than
others) it is the insurer who possesses the statistical information. Is this entrepreneurial
information? While there may be an element of entrepreneurship (in the form of new algorithms
to analyze data), the information is for the most part just a by-product of being in the business. If
you insure claims, you get statistical information on risks. Moreover, knowing the actuarial cost of
products sold in previous years is a by-product of mandatory book-keeping. The logical implication
is that insurers should have a duty to reveal this information.
Note that a duty to reveal how much of the insurance or warranty premium is returned to
customers is less revolutionary than it may seem. In many legal systems, lotteries have a similar
duty to reveal how much of their income is paid out in winnings. Charities often have a similar
duty to reveal how much money is used in the charitable project itself and how much is used for
administrative costs, which makes the internal efficiency of the charity more transparent and
improves competition among charities.
11. No efficient disclosure
11.1. Not publishing full price lists on the Internet (in a standardized form)
Few service providers, such as doctors, plumbers, repair services, car repair shops, or dentists
publish their price lists on the Internet. Courts (and regulators) do not require them to do so. This
increases search costs for consumers and reduces price competition. As a matter of fact, by not
publishing their prices on the internet, those service providers turn an ideal search process into a
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27
less-efficient sequential search process.
That sellers should have a duty to publish complete price lists on the Internet is a logical
implication of the LCIG principle and its corollaries. First, prices are material information—they
are the type of information buyers are naturally interested in. Second, sellers or service providers
are the absolute LCIG of their own prices; this suggests that they should have a duty to disclose,
rather than just no right to misrepresent. Moreover, sellers already have these price lists located
somewhere on a hard drive, so that they would only disclose information that has already been
produced. For buyers (or consumer organizations) on the other hand, it can be costly (or even
impossible) to reverse-engineer the full price lists of non-cooperative sellers. Third, the Internet is
obviously the cheapest, fastest, and most efficient medium for such a task; therefore, it follows
from the principle of efficient disclosure that the Internet should be used to spread price
information.
Ideally, prices should be published in a standardized form; this is a logical implication of the
principle of efficient disclosure. Such standardization is required to reduce search costs and
facilitate easy comparison between products. Standardization starts with a duty to give all products
a unique ID number; this is an essential technical condition for connecting and comparing
information in databases. Note that this type of standardization already exists for some products
such as books (which have an ISBN number). A system of unique product numbers is not especially
hard to implement for mass-produced goods, but this task is more difficult when applied to custommade goods or services (such as blood tests). Since courts are not well equipped to set standards,
agencies, rather than courts, may need to play a role in this aspect.
One reason why sellers (of goods or services) do not spontaneously publish their full price list
on the Internet is that this would not only intensify price competition but also make it harder for
sellers to acquire so-called “information rents” from exploiting information asymmetries. Consider
a plumber who charges $29 for a $1 bolt; this becomes much harder when prices of competing
plumbers are only a mouse-click away. (Moreover, search engines could easily warn consumers
before they even hire a plumber whose prices for spare parts are too much above the wholesale
prices.) But the prevention of such information rents is one of the very goals of a misrepresentation
doctrine.
Note that numerous other sales techniques consist of revealing the price only after a sales
pitch. These techniques violate the principle of efficient disclosure as well.
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11.2. Stealth price increases
In a sequential search process, buyers often keep on buying familiar goods (without looking
for alternatives) as long as the price, quantity, and quality remains unaffected. When prices increase
or quantity or quality decreases, many buyers start to search again to see whether cheaper or better
products can be found.
Sellers who increase prices, therefore, sometimes try to do so in non-conspicuous ways. For
instance, they simply increase prices without explicitly mentioning that prices have increased
(although prices are visible so that attentive buyers may notice the difference), or they keep prices
constant but shrink the quantity delivered.49
While stealth price increases are a common practice, they nevertheless violate the principle of
efficient disclosure. Sellers do disclose the new price, but in a way that minimizes the chances that
buyers will notice it. If courts want to consistently apply the LCIG principle and its corollaries,
stealth price increases would become actionable forms of misrepresentation.
12. Misleading
12.1. Deliberately making products incomparable (concealment)
Apples and oranges are harder to compare than apples and apples. When products are hard to
compare, price competition may be less intense, so that profit margins become higher. Moreover,
when products are hard to compare, sellers may successfully price discriminate between informed
buyers (who know there is no significant difference and therefore will buy the lower-priced
version) and uninformed buyers (who may buy the higher-priced version). Sellers may therefore
intentionally try to make their products hard to compare.50
49
Kotler and Keller, 2012. Marketing Management, p. 403. Poundstone. 2010. Priceless: The Myth of Fair
Value (and How to Take Advantage of It), p. 5: “For such products, consultants recommend creative ways
of "invisibly" shrinking packages. In summer 2008 Kellogg's phased in thinner boxes of Cocoa Krispies,
Froot Loops, Corn Pops, Apple Jacks, and Honey Smacks cereals. No one noticed.”
50
Pricing experts see differentiation as a way to increase profits. See, for instance, Steinmetz, Lawrence L.
and William T. Brooks, How to Sell at Margins Higher than Your Competitors: Winning Every Sale at Full
Price, Rate, or Fee, Hoboken: John Wiley, 2006, p. 26 (“A salesperson must differentiate his or her
company’s product or services from the competitor’s some how, some way. That is what selling is about...”);
Holden, Reed K. and Mark R. Burton, Pricing with Confidence: 10 Ways to Stop Leaving Money on the
Table, Hoboken: John Wiley, 2008, p. 111 (“When products are regarded as commodities, add services to
differentiate products and prop up prices.”) The deeper question is why differentiation would lead to higher
profits. In some cases, the differentiated products are better products; in this case the higher profits are
rewards for entrepreneurship. In other cases, the differentiated products simply increase search costs. In that
case, the higher products are “rewards” for making a market fail.
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Marketing experts have developed several techniques to do so. One is to sell the same product
under different brand names in different stores. (This usually requires using different packaging,
and sometimes using a slightly different design to make buyers believe that the two products are
different, but the products are intrinsically the same.) One specific application of this technique is
the use of so-called private labels. Another technique is to sell the same products in boxes with
different quantities in different shops, and to make sure that the quantity makes it mathematically
difficult to compare. Some goods are sold in boxes of 44 in one shop and in boxes of 26 in another
shop.51 Only math wizards with excellent memories can tell you in which shop the product is
cheaper. An even simpler technique to make two similar products appear different is to give them
different product numbers or names. If the dishwashers sold in one store have a different number
or name than those sold in other stores, buyers may believe that the two are different.52
At first sight, nothing in the law seems to prevent sellers from using such strategies; sellers
are free to bring any product on the market at any price they want. Still, these strategies are
essentially based on artificially increasing search costs. Sellers deliberately create a market failure
(non-transparency) and then exploit it. Should this be considered misrepresentation?
Let us examine whether these marketing strategies violate the LCIG principle and its
corollaries. First, information on the price of a product and its true characteristics and quality is
material—it is socially desirable that such information is produced and known by buyers. Second,
the seller (or manufacturer) is the absolute LCIG of such information regarding her own products,
so that a duty to disclose is justified. Third, disclosure should be done in a conspicuous way,
according to the principle of efficient disclosure. Fourth, the misrepresentation is deliberate—as a
matter of fact, it is a subtle form of concealment—and therefore reasonable reliance should not be
a condition—buyers should not be blamed for falling in the trap that was set for them. And fifth,
while sellers do not explicitly state that the products are different, they do effectively make (at least
a significant minority of) buyers believe that they are different; therefore, they do effectively
mislead.
In sum, these marketing techniques violate the LCIG principle, and they should therefore be
considered actionable misrepresentation.
51
For instance, Breathe Right Nasal Strips (‘Extra’) are sold per 44 in Costco and per 26 in Walmart. A quick
search on the internet reveals that Breathe Right sells its products also in packages of 10, 12, 28, 30 and 50.
52
Another simple technique is to simply not mention the product number. A plumber who gives a quote may
deliberately not mention the product number of the sink; this way, it becomes harder for consumers to
discover that they can get the same for a lower price elsewhere.
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12.2. Making false or exaggerated differentiation claims
Bayer Aspirin costs about three times more than CVS private-label generic aspirin that has
the same active ingredient, dosage, and directions. In a recent empirical study, four economists
found that more sophisticated consumers, such as physicians, pharmacists, or nurses buy the
generic version much more often than others. 53 This suggests that those who pay the brand
premium are simply misinformed.
Misinformed by whom? Sometimes, explicitly by the brand owner. In the 1980s, Bayer stated
that it made the “world’s best aspirin”; it was sued but won with a puffery defense.54 But very often
brand owners do not make any explicit comparative statements. They just state that their product
works and say nothing about the effectiveness of generic alternatives.55
Still, if courts would consistently apply the modern view on what effectively misleads, they
would conclude that brand owners such as Bayer make a misrepresentation. While the brand owner
does not explicitly state something that is literally incorrect, the modern view holds that in order
to examine whether a message is misleading we must look at how the message is likely to be
perceived. (Saying nothing is saying something—and what exactly is implicitly said depends on
the context.) One reason why such statements are likely to be misleading is the social expectation
of “no remark without remarkability.” So if an advertisement informs viewers that a product works
well, it suggests that the product has something remarkable compared to direct alternatives.
Another reason is the social expectation of substantiation. If viewers are recommended to buy a
(more expensive) brand product, viewers expect that the sender of the message has at least some
form of substantiation. Since the brand product is more expensive, the only condition under which
it is rational to buy the brand is that it is better in some respect than the cheaper alternatives. The
viewer of the advertisement expects that the one who makes the recommendation has
substantiation.
A variant of making false differentiation claims is overstating the significance of differences.
Competing products often differ only in relatively minor ways. Marketers and sales people may
want to over-emphasize the differences, but they cannot do so without violating the LCIG principle
53
Bart J. Bronnenberg, Jean-Pierre Dubé, Matthew Gentzkow, and Jesse M. Shapiro, “Do Pharmacists Buy
Bayer? Sophisticated Shoppers and the Brand Premium,” Working Paper, June 2013.
54
In re Sterling Drug, Inc., 102 F.T.C. 395, § II.A.1 (1983). See Preston, p. 53.
55
The CVS and Walgreens packages direct consumers to compare the private label aspirin to Bayer, but
“compare” is an ambiguous statement. It can mean “compare and you will see that it is the same,” or
“compare and you will see that it is different.”
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and its corollaries.
12.3. Deliberately setting the price high to make buyer believe the quality is high
Marketers sometimes set prices deliberately high to signal quality. Suppose there are two
competing products on the market, each with a production cost of $100 and an equal quality. The
price of the first one is set at $110. If the price of the second product is now set at $300, a fully
informed buyer would never buy it. But in reality, it is possible that some will buy it because they
erroneously think the $300 product is better.
The underlying economic mechanism is as follows. In the absence of objective information,
buyers rely on signals. Many buyers will see a high price as a signal for a high quality; this is
rational because prices tend to be correlated with production costs, and production costs tend to be
correlated with quality. Sellers can exploit this rational belief of uninformed buyers by deliberately
setting the price high.
But let us now examine this marketing method through the LCIG lens. The method works
because sellers make buyers believe that the production costs of the $300 product are higher than
those of the $110 product. The seller knows that buyers will make this mistake—it is a mistake
that is deliberately induced by the seller. True, sellers do not explicitly state that their production
costs are higher, but the modern misrepresentation doctrine does not look at literal meanings but at
likely perceived meanings. Since the seller is clearly the LCIG with respect to information on
production costs, it should be the seller’s responsibility to prevent the buyer’s mistake. The seller
can do so by revealing his true production costs (or his markup, which conveys the same
information).
Here is another way to see why such methods should be considered actionable
misrepresentation. Imagine there is a third product on the market that also priced at $300 but costs
$270 to produce. Buyers now see two products priced at $300 but do not know that one has high
production costs and one low production costs. In the absence of objective quality information,
buyers believe that both are high-quality products. In economic terminology, there is a “pooling
equilibrium” in which high-quality and low-quality products are treated alike. This pooling
equilibrium is inefficient because it does not allow buyers to distinguish products on the basis of
true production costs. The only way to obtain a more efficient “separating equilibrium” is to force
the low-quality seller to “reveal his type.”56 The legal system can do so by considering misleading
56
The explanation is similar to the one given in section 13.1.
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messages about production costs as actionable misrepresentation,
13. Misrepresenting material information
13.1. Misrepresenting the honesty of the advice
When buyers cannot instantly see all products on the market, their objectively measured quality
differences, and their final prices, buyers have two options: they can start a sequential search
process themselves (which will be discussed in the following subsections) or they can ask an expert
for advice. When they choose the latter, the honesty of the advice itself is clearly a material fact.
Who is in the better position to know whether an expert gives honest or biased advice? Obviously
the expert herself. This suggests that sellers who pretend to give unbiased advice should be held to
fiduciary standards.
A duty to give honest advice is nothing revolutionary; it already exists in many forms in the
law. CEOs have a “fiduciary duty” toward shareholders, which means that they must always do
what they honestly believe to be in the best interests of the shareholders. Such a fiduciary duty also
exists for anyone who falls under the definition of “agent.” Moreover, under contract law there are
somewhat similar duties for anyone who is in “a relationship of trust and confidence.” But so far,
courts still define “relationship of trust and confidence” too narrowly. It covers doctors, lawyers,
and relatives but it does not cover the “trusted advisers” at a local bank or electronics store or car
dealers. As a result, such sales people can say they give unbiased advice while in practice giving
biased advice.
There is an old Native American story of a boy who met a rattlesnake on a cold day. The
rattlesnake said to the boy, “I am so cold that I cannot even move. Please take me close to your
body, so that I can warm up.” The boy replied, “I wouldn’t dare to do that, because as soon as
you’ve warmed up you will bite me.” But the rattlesnake promised not to bite the boy, saying “I
swear that I will never breach your trust.” So the boy took the rattlesnake and warmed her on his
belly. But when she was warm enough, the snake suddenly bit the boy. “You promised that you
would never bite me!” he said. And the rattlesnake answered: “Yes, that is true. But you should
not have relied on that promise, because you knew I am a rattlesnake.”
When courts refuse to extend a relationship of trust and confidence to sales people who say
they give honest advice, courts apparently see sellers as rattlesnakes. If courts believe that it is
irrational to rely on a salesperson’s advice, why do consumers do it? One reason is that some
salespeople give honest advice. They tell you what is best for you, even if that costs them money.
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To use the language of economists, there are “good types” and “bad types” among sellers. The
“good types” give honest advice; the “bad types” give biased advice. Both purport to give honest
advice. But the legal system does not help us to distinguish between the two because the bad types
are allowed to falsely pretend that they are good types. This leads to what game theorists call a
“pooling equilibrium.” As a result, the “bad types” have an easy time acquiring information rents.
They know better than the consumer which products offer the best value and which offer the highest
markup. They exploit this informational advantage to extract more money from the sale than they
normally could in a transparent market.
The law can easily help the consumers by keeping sellers honest. All that is needed is a legal
duty for salespeople to act as they pretend to be. If they say they give honest advice, they should
be held to that standard. If they want to give biased advice, that is fine, but then they should openly
reveal that, by saying “Do not always believe what I say. I am committed to giving biased advice.
My goal is not to help you but to help my own bank account.”
13.2. Should marketers disclose the fact that they try to exploit behavioral biases?
It is well documented that many store owners now hire consultants who advise them on how
to better exploit behavioral biases of consumers. Such consultants may recommend, for instance,
using decoy pricing techniques. A decoy is a highly priced product that is not expected to be sold,
but that only serves to make less-highly priced products look reasonable.57 Car dealers learn similar
techniques to manipulate potential buyers. One such technique consists of asking a series of
questions to which customers likely to answer “yes.” Then customers are asked whether they would
like to buy options for their new car. Apparently, more customers answer affirmatively when this
technique is used.
The question here is not whether such methods should be allowed but whether sellers who use
them should honestly reveal the fact that they use them. The LCIG principle and its corollaries
suggest that they should. First, information on the fact that a salesperson is using manipulative
techniques is material in a sequential or advice-based search process. Second, the salesperson is
the absolute LCIG about her own use of those techniques. Third, manipulation methods do not fall
under the narrow definition of entrepreneurial information, as explained in section 3.1. Fourth, the
fact that those techniques are used is no longer non-falsifiable, since the fact can usually be proven
57
Koller and Armstrong, p. 321: “… Williams-Sonoma once offered a fancy bread maker at $279. Then it
added a $429 model. The costly model flopped, but sales of the cheaper one doubled.”
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through records of training sessions, staff meetings, or through written scripts.
13.3. How look-no-further stories affect buyers’ decisions
In section 5, I explained that look-no-further stories are material in a sequential search process.
In the following subsections, we examine how look-no-further stories work in practice, and how
they violate the LCIG principle and its corollaries.
In 1976, Arthur Leff wrote a short book entitled “Selling and Swindling,” in which he argued
that there is a remarkable similarity between selling and swindling.58 For the sake of clarity, Leff
did not say that all sellers are swindlers. What he did say is that all swindlers are sellers, and that
swindling is the most difficult form of selling—in other words, swindlers are the Olympians of
selling.
Swindling is different from ordinary stealing, because swindling is a crime that requires the
initial consent of the victim. The victim voluntarily enters into an apparently fair contract, only to
later find out that the contract was not fair or that the promisor never intended to keep her promise.
Swindling is the most difficult form of selling because the deal that is being sold is in reality
completely unattractive to customers.
So swindlers face the same obstacles as sellers—only, their obstacles are much bigger. One
obstacle is that buyers tend to be skeptical about “bargains” because in a perfect market (where
everyone is a “price taker”) there could be no such a thing as a bargain.59 Therefore, swindlers and
sellers have to create explanations about why they can offer a product that is cheaper or better than
what the rest of the market is selling. They need to explain not only how they can sell more cheaply
than the others, but also why they are willing to do so (because they could sell the goods at the full
market price and get even higher profits).
Consider an old pattern of swindling—which Leff called the “Prisoner.”60 A conman tells you
that the king has been captured by the enemy and held in prison (this takes place in Medieval
times). A guard could be bribed for a small amount of money to release the king, and the king
himself has promised that he will reward the person who helps him escape from prison with an
enormous amount of money. Unfortunately, the conman himself has no cash to finance the bribe.
58
Leff, Arthur A., Swindling and Selling: The Story of Legal and Illegal Congames, 1976, New York: Free
Press.
59
Leff, Arthur A., Swindling and Selling: The Story of Legal and Illegal Congames, 1976, New York: Free
Press, p. 119.
60
Leff, Arthur A., Swindling and Selling: The Story of Legal and Illegal Congames, 1976, New York: Free
Press, p. 4, 19–29.
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If you give him some money now, you will later get rich with near certainty. There is no time to
think about the proposal, and the whole plan has to remain an absolute secret. The proposal looks
too good to pass on, and so you decide to pay the money. Later you hear that the whole story was
untrue. Gone is the conman, and so is your money.
If you analyze this swindling pattern (along the lines of Arthur Leff), you will see that there
is something odd about the conman’s proposal. The deal was that you would get millions of dollars
in return for a short-term loan of $10,000. Why would someone ever do that? Why doesn’t the king
pay you $20,000—isn’t that enough? And why wouldn’t the conman keep this great opportunity
for himself? The proposal looks too good to be true. You would think that nobody would ever trust
the proposal.
This is why having a good story is so important. Swindlers know that the facts have to be
constructed so that the market looks seriously distorted. For instance, in the Prisoner scenario, if a
war is being waged, the king has no opportunity to compare competing offers, and there can be no
normal auction because it must be kept secret that a guard will be bribed. It is also clear under these
circumstances that it is not possible to speak with the king to check the facts or discuss the details
of the transaction. Moreover, the promise to pay millions of dollars apparently comes from the
king. The king is not only the most trustworthy individual in the country, but he is also somewhat
outside of the market. Kings do not always want to pay the lowest possible price; sometimes they
are generous to those who do something important for the country.
Another example of a “story” is what Leff called the “Fire Sale.” In this scenario, the
salesman’s story goes something like this: “I had bad luck—there was a fire—and now I need to
quickly sell everything below the market price, which is terrible for me, but good for you.” One
variant of this tale involves the seller pretending to have overstock, basically saying “I had bad
luck, I made the mistake of ordering too much, and now I have to sell it to you at a loss.”
Other stories are meant to explain why only the seller can offer such a great product. The old
version of this story states that the seller owns a secret formula, the modern version that she holds
a patent. Another pattern is what Leff calls the Squaresville Pitch: “I have to give you a lower price,
because you are one of those smarter buyers, and I cannot fool you like the others.” The buyer feels
proud, looks no further, and buys an overpriced product.
Why are stories so important? In a fully transparent market they would not matter: consumers
could compare the price and quality of all products, and would not be interested in the story behind
the proposal. In a non-transparent market, however, stories have become very important. Many
consumers start their search process by going to one seller, and if the price looks fair and the quality
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looks good, the consumer does not look any further; they only keep searching if they get the
impression that the product is overpriced. The story’s function is to convince the consumers that
the price is fair, or even exceptionally good, so that they stop searching.
Moreover, when consumers buy goods at a price that is perceived to be fair, they return to the
store, and probably become even less skeptical in their purchasing. Indeed, many consumers think
that sellers set their prices at cost plus a linear markup. If this were true, it would indeed be
sufficient to check the price of single product. If that product is fairly priced, the seller appears to
work with a low markup rate, and all other products of the same seller can be presumed to be fairly
priced as well.
So far, courts seem to have underestimated the effect of false look-no-further-stories. Even if
the facts are half-truths, or even completely false, courts do not consider such statements to be
illegal misrepresentation, but will find them to be mere “puffery,” or will conclude that it was not
rational for the buyer to believe the story.61 But if we apply the LCIG principle and its corollaries,
it becomes clear that a misleading look-no-further story should be considered actionable
misrepresentation.
13.4. Misrepresenting markups. Should there be a duty to reveal markups?
Now we come to what might be the most counter-intuitive thesis of this paper—that
misrepresentation of markups should be actionable, and that under some conditions sellers should
even have a duty to reveal markups. This may be controversial because it goes against deeply
embedded traditions. Yet it follows directly from the least-cost-information-gatherer principle.
It is true that in an ideal search model—in which buyers instantly get information on all
products on the market, their quality, and their prices—markups are not material. The buyer’s
decision is based on the quality and the price. How much the seller is gaining on the transaction
does not influence the buyer’s decision.
But consider instead a sequential search model, in which buyers go to one seller, receive
information on her product quality and price, and then decide whether to repeat this process or stop
searching. When search processes operate like that, sellers may try to misrepresent markups in
order to make the consumer stop searching. Indeed, if a particular seller asks a very low markup,
it is unlikely that an even lower price will be found elsewhere.
Since markups are material information under those circumstances, and the seller is the
61
Refs common law + FTC
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absolute LCIG of her own markups, this suggests that a duty-to-disclose is justified.
Note that a duty to reveal the markup is unnecessary when there would already be a legal duty
to publish all prices in a standardized form on the Internet. Search engines could then easily connect
the retail prices with the wholesale prices, which would also be published on the Internet in a
standardized form.
13.5. Misrepresenting the seller’s cost structure or motivation
Sellers sometimes make representations of their cost structure (“We are cheaper because we
have no middlemen,” or “we had to increase our prices because our costs went up”) or of the reason
why the seller is able or willing to make the sale (“we have overstock, so we had to lower our
price”). As explained above, such look-no-further stories can be material information in in a
sequential search process. Since the seller is the LCIG and the misrepresentation is intentional, the
seller should be held responsible, and reasonable reliance by the buyer should not be required.
13.6. Misrepresenting market prices or competitor prices; price anchoring and reference pricing
(false or non-substantiated claims)
Information about market prices or competitor prices can be material in a sequential search
process. Since the seller is only the relative LCIG, he should have no duty to disclose the prices of
competing products. But since he is usually the relative LCIG (i.e., better positioned to acquire this
information than the buyer), he should have no right to misrepresent such prices.
One sales technique that may in some cases involve market price misrepresentation is ‘price
conditioning.’ As one price consultant wrote, price conditioning is “the art of changing the
perception of your service pricing.”62
What price conditioning does is to raise the price
expectations. How do you do that? Here is one tip from the price consultant: Mention in a
conversation with a prospective client "Experienced firms can charge upwards of (fill in the blank
with a top end price that is more than you charge) for what you need." The goal of the technique is
to convince clients that the charged price is below the market price. To be true, the technique can
have socially desirable effects when it corrects incorrect beliefs of clients. But when the reference
price is deliberately set above the real market price, the method misrepresents material information.
62
Berman, “Why Lawyers Need To Understand The Art of Price Conditioning,”
http://www.lawmarketingmonitor.com/law-practice-management/do-you-offer-a-higher-pric... 7/8/2011,
posted by Jeff Berman on July 27, 2010.
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13.7. Misrepresenting what other customers pay; price discrimination based on search costs
Information about what other consumers pay is material in a sequential search process. If you
know that you pay more than most others, it may be worthwhile to look further. If you know that
you pay less than the others, chances are small that you will find a better deal. By the same token,
information on list prices and previous prices can be material in a sequential search process.
Because this information is material, sellers may have an incentive to misrepresent what other
customers pay or paid in the past. The LCIG principle and its corollaries suggest that such
misrepresentations should not be tolerated by courts.
Studies have shown that car dealers price discriminate as a function of the buyers’
sophistication. Car dealers are not alone in this respect—price discrimination based on search costs
has become prevalent in modern markets. But very often such a form of price discrimination will
not be possible without making any form of misrepresentation. As one price consultant wrote, “Of
course, the goal of a good salesperson is to make us feel like we got the best possible deal.”63 This
is definitely true as a descriptive statement. But making someone believe she got the best possible
deal when she paid more than average is a misrepresentation of the normally paid price. The LCIG
principle suggests that no immunity should be given to the makers of such misrepresentations.
14. Conclusion
This paper has argued that caveat emptor is dead as a general legal principle. Modern law is
now best explained by the least-cost-information-gatherer principle. But in practice, caveat emptor
is kept alive in a wider set of cases than is economically justified by the inconsistent application of
the least-cost-information-gatherer principle.
For instance, courts do not create as many disclosure duties in contract law as a consistent
application of the LCIG principle dictates. When there is a duty to disclose, the legal system does
not always require that the information be disclosed in the most efficient way. Courts do not always
correctly apply the materiality criterion; they seem to insufficiently realize that what is material
depends on the type of search process. For instance, they do not always realize that look-no-further
stories have a strong effect on buyers’ decisions in a sequential search process. Courts also
insufficiently realize the misleading nature of some statements. Occasionally, courts err by blaming
63
Mohammed. 2005. The Art of Pricing: How to Find the Hidden Profits to Grow Your Business, New York:
Crown Business, p. 141.
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buyers for falling into a trap that was set for them.
The consistent application of these principles would likely have a significant effect on markets.
Many common marketing methods and sales techniques that are currently falling through the
cracks of the legal system would become actionable forms of misrepresentation. While some of
these recommendations (such as a general duty to publish full price lists on the Internet, or to reveal
markups in some cases) may look far-reaching, they follow directly from obvious economic
principles and general legal principles that are currently effectively applied by courts, be it
inconsistently.