Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 11

Logistics Midterm will (hopefully) be returned Wednesday HW2 also returned Wednesday HW3 will be up later this week – due Fri Nov 5

Contract law: the story so far Contract = legally binding promise Allow for cooperation/trade when transactions aren’t instantaneous First purpose of contract law: enable cooperation What promises should be enforced? Bargain theory: those given as part of a bargain Three elements: offer, acceptance, consideration Efficiency: any promise both promisor and promisee wanted to be enforceable Information Asymmetric/private info can prevent trade; contract law can help Second purpose: encourage efficient disclosure of information Why do we need contracts? …agency game: my inability to commit to a future action led to a breakdown in cooperation …first purpose of contract law: enable cooperation, in settings where trade does not occur all at once

Contract law: the story so far When should promises be broken? Breach of contract is efficient when cost to perform > benefit of performance to promisee Breach is in promisor’s interest when cost to perform > promisor’s liability from breach Expectation damages: liability from breach = benefit to promisee Leads to breach exactly when it’s efficient We can think of this as “designing the law to internalize an externality” Third purpose of contract law: obtain optimal commitment to performance Why do we need contracts? …agency game: my inability to commit to a future action led to a breakdown in cooperation …first purpose of contract law: enable cooperation, in settings where trade does not occur all at once

Reliance

Reliance You expect an airplane to arrive in spring – you might… Build yourself a hangar Sign up for flying lessons Buy a helmet and goggles Reliance – investments which depend on performance Reliance increases the value of performance to promisee Reliance increases the social cost of breach The fourth purpose of contract law is to secure optimal reliance I’m an airplane builder You come to me in the fall and order an airplane, which I will build over the winter and deliver in the spring Now that you’re expecting an airplane in the spring, there are a bunch of things you might do You might build yourself a hangar – a covered parking space for the plane You might sign up for flying lessons You might buy an awesome leather helmet and aviator goggles, so you can look like this guy Similarly, the farmer who has mailed in a check for $25 for a sure means to kill grasshoppers might plant more crops, since he’s no longer worried about the risk of grasshopper damage Similarly, the nephew whose uncle promised him a trip around the world might go out and buy a backpack, or a linen suit to wear in the tropics All of these are examples of reliance – investments whose value depend on performance of the promise Another way to think about it: reliance is any investment which increases the value of performance to the promisee In many cases, making these investments early is efficient if you wait to build a hangar until I deliver your airplane, it might get damaged in a storm before the hangar is complete if the nephew waits to buy a linen suit until his uncle sends him plane tickets, he might miss a big spring sale. On the other hand, we’ve already introduced the idea of efficient breach, and the idea that the promisor may not always perform (and that this may be OK) But this means that reliance is not a sure thing Since reliance increases the value of performance, reliance also increases the social cost of breach – you’ve built a hangar for nothing, or you resell the helmet and goggles at a loss And this brings us to: The fourth purpose of contract law is to secure optimal reliance.

When is reliance efficient? When social benefit of reliance > social cost of reliance Social benefit is increased benefit to promisee (Value of airplane + hangar) – (Value of airplane without hangar) Value is only realized if the promise is performed Social cost is cost borne by promisee Cost occurs whether or not promise is performed Reliance is efficient if Increase in value of performance Probability of performance Cost of investment X >

Reliance and damages Reliance is efficient if (increase in value) X (probability of performance) > (cost) Can we design damages to get efficient reliance? We know expectation damages lead to efficient breach Expectation damages = expected benefit from performance If reliance increases anticipated benefit, does it increase expectation damages in event of breach?

Reliance and damages: example Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000 Reliance and damages: example You’re buying an airplane from me Price is $350,000, to be paid on delivery Airplane alone gives you benefit of $500,000 Building a hangar costs $75,000 Airplane with hangar gives you benefit of $600,000 Without hangar, expectation damages = $150,000 If you build a hangar and I fail to deliver plane, do I owe… $150,000? (Value of original promise) $250,000? (Value of performance after your investment) $225,000? (Value of original promise, plus reimburse you for investment you made) Some other amount?

If exp damages include benefit from reliance… Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000 If exp damages include benefit from reliance… If you don’t build hangar, your payoff will be… $150,000 if I deliver the plane ($500,000 – $350,000) $150,000 if I breach and pay expectation damages If you build hangar, your payoff will be… $175,000 if I deliver the plane ($600,000 – $350,000 – $75,000) $175,000 if I breach and pay (higher) expectation damages So if expectation damages include the increased value of performance due to reliance investments… You’ll invest whenever (increase in benefit) > (cost) In this case, you’ll invest (because $100,000 > $75,000)

If exp damages include benefit from reliance… Price of plane = $350,000 Value of plane = $500,000 Cost of hangar = $75,000 Value of plane + hangar = $600,000 If exp damages include benefit from reliance… If expectation damages include increased value of performance, you’ll invest for sure Is this efficient? Reliance is efficient if (increase in benefit) X (probability of performance) > (cost) $100,000 X (probability of performance) > $75,000 Only efficient if probability of performance > ¾ If probability of performance < ¾, reliance is inefficient, but happens anyway Overreliance!

X + X > X > Overreliance If reliance investments increase the damages you’ll receive in the event of breach, you’ll over-rely You’ll rely if Efficient to rely if So overreliance guaranteed if damages increase when you make reliance investments Your investment causes an externality Increase in benefit X Prob. of perform. + Increase in damages X Prob. of breach > Cost of investment Increase in benefit X Prob. of perform. > Cost of investment

Reliance and breach Just showed: to get efficient reliance, ignore reliance investments when calculating expectation damages But if we do that… Then promisor’s liability from breach < promisee’s benefit from performance Which means: inefficient breach “Paradox of compensation” Single “price” (damages owed) sets multiple incentives… …impossible to set them all efficiently!

So what do we do? Cooter and Ulen: include only efficient reliance Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount So promisee rewarded for efficient reliance, not for overreliance So how do we fix this? Cooter and Ulen adjust their definition of expectation damages in the following way: Perfect expectation damages restore the promisee to the level of well-being he would have had, had the promise been kept, and had he relied the optimal amount (This is why they attach the word “perfect” to expectation damages) Thus, the promisee is rewarded for efficient reliance this increases his payoff from performance of the promise, and also increases his payoff from breach, since it increases the amount of damages he receives But the promisee is not rewarded for excessive reliance – overreliance damages are limited to the benefit he would have received given the optimal level of reliance. It’s a nice idea, but it seems like it would be very hard in general for a court to determine after the fact what the optimal level of reliance was (It might also be hard for the promisee to know this, since he may not know the probability of breach.)

So what do we do? Cooter and Ulen: include only efficient reliance Perfect expectation damages: restore promisee to level of well-being he would have gotten from performance if he had relied the efficient amount So promisee rewarded for efficient reliance, not for overreliance Actual courts: include only foreseeable reliance That is, if promisor could reasonably expect promisee to rely that much What is actually done in practice? The usual rule is that liability is limited to the level of reliance that is foreseeable. Reliance is foreseeable if the promisor could reasonably expect the promisee to rely that much under the circumstances Reliance is unforeseeable if it would not be reasonably expected American and British law tend to define overreliance as unforeseeable, and therefore noncompensable. An example of unforeseeable reliance telegraph company fails to transmit a stockbroker’s message, resulting in millions of dollars in losses the telegraph company could not reasonably expect the stockbroker to rely that heavily on one message so the telegraph company would not be liable for the full extent of the losses Another example: the rich uncle’s nephew, when he was promised a trip around the world, goes out and buys “a white silk suit for the tropics and matching diamond belt buckle”. After the uncle refuses to pay for the trip, the nephew sells the suit and belt buckle at a loss, and sues his uncle for the difference The court might find the silk suit foreseeable reliance, but the diamond belt buckle unforeseeable, and only award him the loss on the suit. (The book points out that “in American law, gift promises are usually enforceable to the extent of reasonable reliance.”)

Foreseeable reliance: Hadley v Baxendale 1850s England Hadley owned gristmill, mill shaft broke Baxendale’s firm hired to transport shaft for repair Baxendale shipped by boat instead of train, making it a week late Hadley sued for the week’s lost profits “The shipper assumed that Hadley, like most millers, kept a spare shaft. …Hadley did not inform him of the special urgency in getting the shaft repaired.” Court listed several circumstances where broken shaft would not force mill to shut down Ruled lost profits not foreseeable  Baxendale didn’t have to pay Reliance is part of the issue in the famous case of Hadley v Baxendale, a precedent-setting English case decided in the 1850s I give a link to the actual court decision on the syllabus Here is Cooter and Ulen’s summary of the case: Hadley owned a gristmill; the main shaft of the mill broke; and Hadley hired a shipping firm where Baxendale worked to transport the shaft for repair. The damaged shaft was the only one in Hadley’s mill, which remained closed awaiting return of the repaired shaft. The shaft was supposed to be delivered in one day Baxendale decided to ship it by boat instead of by train, and as a result, it arrived a week late Hadley sued for the profits he lost during that extra week in which the mill was shut down Quoting again: The shipper assumed that Hadley, like most millers, kept a spare shaft. The shipper contended that Hadley did not inform him of the special urgency in getting the shaft repaired. The shipper prevailed in court on the damages issue, and the case subsequently stands for the principle that recovery for breach of contract is limited to foreseeable damages. The ruling was that the lost profits were not foreseeable the court specifically listed several circumstances in which a broken crankshaft would not force a mill to shut down Baxendale was only held liable for damages he could reasonably have foreseen However, this isn’t only a question of reliance Part of the issue is that Hadley knew about the urgency of getting the crankshaft fixed quickly, but did not tell Baxendale Recall on Tuesday, we said that the second purpose of contract law is to encourage the efficient disclosure of information We’ll come back to this question of information shortly.

Another experiment: is trust a problem?

A two-player game, similar to the investment/agency game Player A starts with $10 Chooses how much of it to give to player B That money is tripled Player B has $10, plus 3x whatever A gave him/her Chooses how much (if any) to give back to player A We’ll try the game three ways: Anonymously – A and B don’t know who each other are Face to face – A and B know who each other are, and can discuss the game before playing, but their actions remain private In public – A and B play out loud in front of the whole class

Default Rules

Default rules Gaps: risks or circumstances that aren’t specifically addressed in a contract Default rules: rules applied by courts to fill gaps In a world without any transaction costs, the two sides to a contract could spell out exactly what should occur in every possible contingency what happens if the cost of sheet metal rises what happens if my uncle wants my painting what happens if a shipment is delayed, and so on This would make contract law much simpler – courts could simply enforce the letter of the contract, since nothing was left unclear However, in reality, some circumstances are impossible to foresee And even if they weren’t, the cost and complexity of writing a contract to deal with every possibility would make perfect contracts unworkable Risks or circumstances that aren’t specifically addressed in a contract are called gaps; default rules are rules that the court applies to fill in these gaps. Gaps can be inadvertent or deliberate Our contract to sell you my painting might not have addressed my uncle wanting the painting because I didn’t know he was coming to visit, or because I never would have imagined he would be so excited about it On the other hand, we could have imagined that it was at least possible for the price of raw materials for building an airplane to go up significantly But we might have felt it was such a remote risk that it was not worth the time and effort to build it into the contract.

Default rules Gaps: risks or circumstances that aren’t specifically addressed in a contract Default rules: rules applied by courts to fill gaps Writing something into a contract vs leaving a gap Allocating a loss (ex post) Versus allocating a risk (ex ante), before it becomes a loss The decision to leave a gap or to fill it (specifically address a particular contingency) is the difference between allocating a loss after it has occurred (ex post) and allocating a risk before it becomes a loss (ex ante) At the time I agree to build you an airplane, there is some risk that the cost of raw materials will go up We can choose to worry now about who should bear that risk Or we can leave it out of the contract, and if that risk becomes a loss (that is, if the costs do go up), then we can worry about who should bear the loss In the first case, allocating the risk, the cost of adding it to the contract is definitely incurred But in the second case, allocating a loss that has occurred, the cost of allocating the loss is only incurred when the loss occurs Thus, it is often rational to leave gaps when the risk is very remote But this means that courts must decide what “default rules” should apply to circumstances that are not addressed in a contract That is, what rules should fill the gaps that are left in imperfect contracts The next obvious question is: what should these default rules be? We will look at two different views of this

What should default rules be? Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue This will be whatever rule is efficient Cooter and Ulen answer this question by going back to the Normative Coase view: the law should be structured to minimize transaction costs Since filling a gap in a contract requires some cost, the default rule should be the rule that most parties would want if they chose to negotiate over the issue This way, most contracts will not have to address this particular rule – they can use the default rule – and therefore avoid additional transaction costs And the rule that most parties would want is whatever rule is efficient. They give an example A construction company has contracted to build a house for a family, and there is some risk of a worker strike at the company which would delay completion Suppose that the company can bear the risk of a strike at a cost of $60, and that the family can bear the risk at a cost of $20 (It might be cheaper for the family to bear the risk because they could stay with friends for a while if the house were delayed; if the company held the risk, it might have to pay for a hotel for the family.) (Also note that these numbers are low not because a strike would have low costs, but because a strike might be fairly unlikely, so the expected cost is fairly low.)

What should default rules be? Cooter and Ulen: use the rule parties would have wanted, if they had chosen to negotiate over this issue This will be whatever rule is efficient Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules Do this by imputing the terms the parties would have chosen if they had addressed this contingency If the risk were not addressed by the contract, the default rule would apply. If the default rule were for the construction company to bear the risk, this would be inefficient in this case The parties could create an additional $40 of surplus by overruling the default rule (addressing the risk) So as long as the transaction cost of allocating the risk were not too large, they would choose to do so, but incur this transaction cost. On the other hand, if the default rule were for the family to bear the risk, they would not need to address the risk in the contract, and would not incur the transaction cost. This brings Cooter and Ulen to their fifth pronouncement: The fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules. They also offer a simple rule for doing this: Impute the terms to the contract that the parties would have agreed to if they had bargained over the relevant risk. That is, figure out what terms the parties would have chosen if they had chosen to address a risk, and let those be the default rule.

Default rules Don’t want ambiguity in the law So default rule can’t vary with every case Majoritarian default rule: the terms that most parties would have agreed to In cases where this rule is not efficient, parties can still override it in the contract Court: figure out efficient allocation of risks, then (possibly) adjust prices to compensate Of course, you don’t want a lot of ambiguity in the law So you don’t want the default rule to vary constantly with the particular circumstances of a given case So what’s more practical to do is to set the default rule to the terms that most parties would have agreed to This is called a majoritarian default rule In circumstances where this is not the efficient rule, the parties are still free to contract around it, that is, to put terms in the contract that override the default rule If the parties had chosen to address a particular risk, it’s safe to assume that they would have allocated it efficiently That is, as long as the parties were choosing to consider a risk, they would allocate it in the way that led to the highest total surplus, and then compensate the party who bears the risk for bearing it Thus, this is what the court would need to do to figure out the efficient default rule: it should figure out the efficient allocation of risks, and then adjust prices in a reasonable way

Default rules Example: probability ½, the cost of construction will increase by $2,000 Construction company can hedge this risk for $400 Family can’t do anything about it Price goes up – who pays for it? The book gives an example of this: a family is having a house built The family and the construction company are negotiating a contract The construction company knows that with probability ½ , the price of copper pipe will go up in such a way as to increase the cost of construction by $2,000 So in expectation, the cost of construction will be $1,000 higher due to this risk The company can hedge against this risk (by buying copper pipe in advance and then paying to store it somewhere) at a cost of $400 Assume that the family has no reason to know anything about the cost of copper pipes, and therefore does not anticipate the risk or have any way to mitigate it. The company chooses not to hedge this risk; the price of copper pipes does go up The company builds the house and bills the family $2,000 more than they had expected The family refuses to pay, and the case goes to court The original contract does not say anything about the risk of rising copper prices. So how would the court address this?

Default rules Example: probability ½, the cost of construction will increase by $2,000 Construction company can hedge this risk for $400 Family can’t do anything about it Price goes up – who pays for it? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction company Should prices be adjusted to compensate? First, the court must decide to whom the contract would have allocated this risk, if it had addressed it. Then it must adjust prices to reflect this. In this case, the cost of bearing the risk would be $1,000 to the family (since they have no way to mitigate it), but $400 to the company (since hedging the risk is cheaper than bearing it) So the company is the efficient bearer of the risk That is, an efficient contract would have allocated this risk to the construction company Next, the court must consider whether the price should be adjusted In this case, the court might rule that the risk of a spike in copper prices was foreseeable The construction company foresaw, or should have foreseen, that this risk was present So the court could assume that the price the parties negotiated already included compensation for bearing this risk

Default rules Example: probability ½, the cost of construction will increase by $2,000 Construction company can hedge this risk for $400 Family can’t do anything about it Price goes up – who pays for it? Construction company is efficient bearer of this risk So efficient contract would allocate this risk to construction company Should prices be adjusted to compensate? On the other hand, there are some risks that are unforeseeable Suppose that the leader of the copper miners’ union in Peru died, and there was a battle to succeed him, and that his replacement called a strike to flex his muscles, and that this strike was what led to the increase in copper prices Here, it’s reasonable that neither party would have foreseen the risk. In this case, the construction company might still be the efficient bearer of this risk – since they might be able to make changes to the construction plan to use less copper and more of other materials But since the risk was unforeseen, it was not included in the negotiated price So the court might adjust the price paid to the construction company, to compensate them for the risk; but then still hold the construction company responsible for the extra $2,000 in costs Thus, the ruling might be that the family should pay some smaller amount – say, $700 – which is what the company would have needed to receive as compensation for bearing this risk – but that the company was then responsible for the rest of the $2,000. (The book then continues this story to give another example of overreliance and breach – check it out if you’re still confused about these points.)

Default rules So, Cooter and Ulen say: set the default rule that’s efficient in the majority of cases Most contracts can leave this gap, save on transaction costs In cases where this rule is inefficient, parties can contract around it So the rule in Cooter and Ulen is fairly straightforward: Courts should set default rules that are efficient in the majority cases, so that… most parties can leave that risk unaddressed and save on transaction costs while parties can contract around this rule in circumstances where it is not efficient.

Default rules: a different view Ian Ayres and Robert Gertner, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules” Sometimes better to make default rule something the parties would not have wanted To give incentive to address an issue rather than leave a gap Or to give one party incentive to disclose information “Penalty default” Ian Ayres and Robert Gertner offer a very different take on default rules, in the article on the syllabus, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules.” They argue that in some instances, it is better to make the default rule something the parties would not have wanted Either to give the parties an incentive to specifically address an issue rather than leaving a gap Or to give one of the parties an incentive to disclose information They refer to this type of intentionally-inefficient default rule as a penalty default Ayres and Gertner argue that in some cases, gaps are left not because the of the transaction costs of filling them, but for strategic reasons One party might know that the default rule is inefficient; but negotiating around the default rule would require him to give up some valuable information, so he might be tempted not to But hiding this information is inefficient; a penalty default would force him to disclose it

Penalty defaults: Hadley v Baxendale Baxendale (shipper) is only one who can influence when crankshaft is delivered; so he’s efficient bearer of risk If default rule held Baxendale liable, Hadley has no need to tell him the shipment is urgent So Hadley might hide this information, which is inefficient Ayres and Gertner: Ruling in Hadley was a good one, not because it was efficient, but because it was inefficient… …but in a way that created incentive for disclosing information Consider again the case of Hadley v Baxendale, the miller with the broken crankshaft While the crankshaft is en route, Hadley’s mill is not operating, so he’s losing money Baxendale, the shipper, is the only one who can influence when the crankshaft is delivered; so he is likely the efficient bearer of this risk (It was his choice to ship the crankshaft by boat, rather than by rail, that led to the delay.) If the default rule were for Baxendale to be responsible for any lost profits, however, Hadley has no incentive to tell him how urgent the shipment is In fact, he is likely to not want to mention it; if he made it clear how important the crankshaft was, Baxendale might try to charge him a higher price for delivery! So a default rule holding Baxendale responsible for lost profits due to delay would lead Hadley not to disclose the urgency of his shipment And this would be inefficient, since it could lead to Baxendale making a bad decision about what method of shipment to use (this is what happened) On the other hand, a default rule that Baxendale is not responsible for lost profits seems to be inefficient we just argued that Baxendale is the efficient bearer of this risk This gives Hadley an incentive to try to negotiate different terms in the actual contract Over the course of the negotiations, the urgency would become apparent Baxendale would agree to take on the risk But he would also know the costs of delay, and could plan around them better. So Ayres and Gertner argue that the ruling in Hadley was a good one Not because the default rule was efficient But because it was inefficient in a way that created good incentives In this case, the incentive for the better-informed party to disclose information (In this sense, the default rule is a “penalty default:” it penalizes the better-informed party, giving an incentive to contract around the default.)

Penalty defaults: other examples Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this Consider a real estate broker who is handling the sale of a house by a private seller to a private buyer When a buyer’s offer is accepted, he puts down a deposit, called “earnest money,” to show that he is serious If he then backs out of the deal, he doesn’t get this earnest money back The question remains, though, how should the earnest money be divided between the seller and the broker? Both the broker and the seller are inconvenienced by the breach; it’s not really clear who is the efficient bearer of this risk However, what is clear is that the broker probably knows more about real estate law than the seller The broker is a professional, who does this type of transaction for a living The seller might be selling a house for the first time. If the default rule allowed the broker to keep the earnest money, the broker has no reason to bring this up when negotiating a contract with the seller But the seller might not know to bring this up; the seller might have no idea about earnest money, and not realize that this was another point that could be negotiated with the broker. On the other hand, if the default rule gave the earnest money to the seller, the broker would have a clear incentive to raise this with the seller And so they could negotiate whatever was the efficient allocation of the earnest money. Thus, whether or not it’s efficient, a default rule favoring the less-informed party once again gives an incentive to disclose information, which may be desireable.

Penalty defaults: other examples Real estate brokers and “earnest money” Broker knows more about real estate law Default rule that seller keeps earnest money encourages broker to bring it up if it’s efficient to change this Courts will impute missing price of a good, but not quantity Forces parties to explicitly contract on quantity, rather than leave it for court to decide Ayres and Gertner give another nice example of penalty defaults used for a different purpose When a contract does not specify a price for a good, courts will tend to impute whatever the market price was at the time of the transaction That is, they will enforce the contract, and just impose the market price However, when a contract does not specify a quantity, courts will refuse to enforce the contract This means the default rule for price is the market price, but the default rule for quantity is 0 A quantity of 0 cannot possibly be what the parties would have wanted Nobody would go through the hassle of signing a contract in order to transact no goods So what is the reason for this default rule? Ayres and Gertner argue it is a penalty default, to force the parties to decide on a quantity Why should the parties be forced to decide on a quantity and not a price? Because it’s easier (cheaper) for the court to fill in the price than the quantity The rule for figuring out the price the parties would have agreed to is easy – the court can usually ascertain the market price of a given good on a given date However, if the court had to impute the quantity the parties would have wanted, this is much more difficult The court would have to figure out the marginal value of an incremental unit of the good to each side to figure out the efficient amount to transact Thus, shifting the burden of calculating the right quantity from the parties in the contract to the courts is inefficient So the default rule forces the parties to decide on the quantity themselves.

When to use penalty defaults? Look at why the parties left a gap in contract Because of transaction costs  use efficient rule For strategic reasons  penalty default may be more efficient Similar logic in a Supreme Court dissent by Justice Scalia Congress passed a RICO law without statute of limitations Majority decided on 4 years – what they thought legislature would have chosen Scalia proposed no statute of limitations; “unmoved by the fear that this… might prove repugnant to the genius of our law…” “Indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.” Ayres and Gertner do not argue penalty defaults should always be used, only that they are appropriate in certain circumstances They basically argue that we need to look at why parties to a contract leave a particular type of gap When gaps are left due to transaction costs of filling them, efficient defaults make sense However, when gaps are left strategically – by a well-informed party who chooses not to contract around an inefficient default in order to get “a bigger share of a smaller pie” – penalty defaults may be more efficient. In the conclusion to their paper, Ayres and Gertner cite a similar point from a dissent by Supreme Court Justice Scalia The legislature had passed a RICO (racketeering/corruption) statute and had not specified a statute of limitations The Court was therefore being asked to decide on the statute of limitations The majority set the statute of limitations at 4 years, figuring that’s what the legislature most likely would have chosen had they remembered to specify it Scalia proposed no statute of limitations He was “unmoved by the fear that this… might prove repugnant to the genius of our law” Instead, he pointed out, “indeed, it might even prompt Congress to enact a limitations period that it believes appropriate, a judgment far more within its competence than ours.” So his view: rather than do what Congress would have wanted, do something they would not have wanted, to force them to do it themselves next time Exactly the same idea as a penalty default for a contract It’s a pretty cool article – take a look if you’re interested.

Regulations (don’t expect to get to this)

Default rules versus regulations Default rules can be contracted around Some rules cannot – immutable rules, or mandatory rules, or regulations Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations. Coase: if individuals are rational and there are no transaction costs, private negotiations lead to efficiency So additional regulations can only make things worse But when people are not rational, or when there are transaction costs/market failures, regulations may help Default rules are rules which hold when a contract leaves gaps, but which parties to a contract are free to contract around That is, by specifying what should happen in a particular situation, the parties can override the default rule If the default rule did not hold shippers liable for unforeseen losses, Hadley and Baxendale could still choose negotiate a contract under which the shipper was liable for all losses However, there are some rules that cannot be contracted around Ayres and Gertner refer to these as immutable rules Cooter and Ulen refer to them as mandatory rules, or as regulations Their Fifth Purpose of Contract Law, which we mentioned earlier, is actually, The fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules AND REGULATIONS. What are the circumstances where regulations, or mandatory rules, or immutable rules, make sense? That is, in what circumstances should a rule be made that individuals are not able to voluntarily contract around? Think back to Coase If individuals are rational and there are no transaction costs, private negotiations (in this case, contracting) will lead to efficiency So if individuals are rational and there are no transaction costs, any additional regulation would just get in the way On the other hand, when individuals are not rational, or when there are transaction costs or market failures, regulation/immutable rules might be efficient Next week, we will look at a bunch of these cases.

One example of a regulation/immutable rule: derogation of public policy Derogate, verb. detract from; curtail application of (a law) Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable Contracts which could only be performed by breaking a law Contracts whose effect is to circumvent a law One example of an immutable rule: derogation of public policy Contracts which derogate public policy are not enforceable A contract is not enforceable if its completion would require violating the law. Obvious examples of this would be a sales contract for a kilo of cocaine, or a contract to kill someone However, there are also less obvious situations where an apparently legal contract would have the effect of circumventing a law, and the contract is therefore unenforceable In the U.S., labor unions have a statutory obligation to bargain with management “in good faith” A contract between a labor union and a third party, which would violate this obligation, would therefore derogate public policy, and not be enforced An example of this is a contract that “ties the union’s hands” in negotiations Suppose that the union (B) and ownership (C) at a factory are bargaining over wages The union wants its workers to earn $15 an hour, ownership is offering $10 an hour, and negotiations are ongoing. Now the union goes to a competing factory owner (A) and signs the following contract: “If I ever agree to work for C for less than $15 an hour, I promise to have all my members work for you for $1 an hour.” The intent of the contract is not for it to actually happen, just to change the union’s bargaining position with C, by “burning its bridges,” that is, making it much more costly to back down from its demands. Since this would violate the union’s obligation to bargain in good faith, this contract would not be enforced. “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr” A (other factory) B (union) C (ownership)

One example of a regulation/immutable rule: derogation of public policy Derogate, verb. detract from; curtail application of (a law) Contracts which derogate public policy – that is, contradict a law or regulation – are not enforceable Contracts which could only be performed by breaking a law Contracts whose effect is to circumvent a law Other examples of contracts which would derogate public policy. A victim of a crime offering a policeman a reward for solving the crime The police’s job is to solve crimes Allowing rewards might distort the focus toward crimes with rewards, away from more important crimes without rewards A contract among competitors to act as a cartel, similar to a monopoly A contract that fixed prices, say, would derogate laws designed to foster competition, and would therefore be unenforceable. “if I ever work for C for less than $15/hr, I’ll work for you for $1/hr” A (other factory) B (union) C (ownership)

Derogation of public policy In general: contracts which can only be performed by breaking the law are not enforceable But… “A married man may be liable for inducing a woman to rely on his promise of marriage, even though the law prohibits him from marrying without first obtaining a divorce.” “A company that fails to supply a good as promised may be liable even though selling a good with the promised design violates a government safety regulation.” “A company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation.” “A promisor should be liable for breach if he knew that the promise was illegal” In general, contracts which can only be performed by breaking the law are not enforceable However, there are still some instances where, even though performing would require laws to be broken, a contract is still enforced, that is, a remedy is still supplied for breach Three examples from the textbook: “A married man may be liable for inducing a woman to rely on his promise of marriage, even though the law prohibits him from marrying without first obtaining a divorce.” “A company that fails to supply a good as promised may be liable even though selling a good with the promised design violates a government safety regulation.” “A company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation.” In all these examples, the liability rests with the party that knew, or should have known, that it was committing to something illegal This is similar to the reasoning in Ayres and Gertner Putting the liability on the informed party gives them an incentive to be honest (or in these cases, to not enter into this type of contract) Cooter and Ulen argue that the promisor should be liable for breach if he knew (or should have known) that the promise was illegal but the promisee did not On the other hand, the promisor should not be liable if he did not know the promise was illegal and the promisee did.

Expectation damages: default rule or immutable rule? Peevyhouse v Garland Coal and Mining Co (OK Supreme Court, 1962) Garland contracted to strip-mine coal on Peevyhouse’s farm Contract specified Garland would restore property to original condition; Garland did not Restoration would have cost $29,000… …but “diminution in value” of farm only $300 Original jury awarded $5,000 in damages, both parties appealed Oklahoma Supreme Court reduced damages to $300 Derogation of public policy is one example of an immutable rule, or a regulation – a rule that the parties to a contract cannot overrule Most of what we’ve done up to now has been focused on default rules – rules which hold when the parties chose not to overrule them For example, we said that expectation damages lead to efficient breach, and that they were therefore a good rule for contracts that did not specify damages However, we never said that expectation damages should be a mandatory rule That is, we never said parties should not be able to specify a different remedy for breach However, there is a legal precedent for a court imposing expectation damages (or something like them) even when the contract seemed to call for a different remedy The case is Peevyhouse v Garland Coal and Mining Company (OK Sup Ct, 1962) Peevyhouse owned a farm in Oklahoma Garland contracted to strip-mine some coal on the property The contract specified that Garland would take certain steps to restore the property to its previous condition after mining the coal After mining the coal, Garland made no attempt to take these restorative steps It was estimated at trial the restoration would cost $29,000 Peevyhouse sued for about that much ($25,000) The parties agreed during trial that everything else in the contract had been performed The defendant introduced evidence that although the damage would cost $29,000 to repair, it lowered the value of the plaintiffs’ farm by only $300 (The “diminution in value” of the farm due to the damage was $300.) Original jury awarded Peevyhouse $5000 in damages; both sides appealed to OK Sup Ct Peevyhouse saying this was less than the service that had been promised Garland saying this was still more even than the total value of the farm after repairs The OK Supreme Court reduced the damage award to $300.

Expectation damages: default rule or immutable rule? Seems like classic case of efficient breach Performing last part of contract would cost $29,000 Benefit to Peevyhouses would be $300 Efficient to breach and pay expectation damages, which is what happened But… Most coal mining contracts: standard per-acre diminution payment Peevyhouses refused to sign contract unless it specifically promised the restorative work Dissent: Peevyhouses entitled to “specific performance” At first glance, this seems like a nice example of efficient breach Performing the last part of the contract would cost $29,000 The benefit to the Peevyhouses would be $300 So it is efficient to breach and pay expectation damages, which is what was awarded However, the dissenting opinion noted that the coal company was well aware of what they were getting into when they signed the contract Most coal mining contracts at that time contained a standard per-acre diminution payment, that the coal company would pay instead of repairing the property The Peevyhouses specifically rejected that clause of the contract during initial negotiations, and would not sign the contract unless it specifically promised the restorative work The dissent argued that the Peevyhouses were therefore entitled to “specific performance” of the contract, that is, to have the restorative work completed as promised. Even though objectively, the damage to the property diminished its value by only $300, the Peevyhouses’ subjective value appears to have suffered much more Expectation damages are meant to make the promisee as well off as they would have been under performance – here, this seems not to be the case. At least one scholar has claimed that the judges who decided Peevyhouse were either incompetent or corrupt one was later impeached, and others resigned although others have disagreed Still, it appears that the ruling here attempted to turn an efficient default rule – expectation damages – into a mandatory rule, that is, a rule that would be enforced even when it was not what the parties intended at the time of the contract.

We can also think about Peevyhouse in terms of penalty defaults Which works better in this case: Default rule allowing Garland to breach and pay diminution fee? Default rule forcing Garland to perform restorative work? Ayres and Gertner: default rule should “penalize” the better-informed party Garland routinely signed contracts like these Peevyhouses were doing this for the first time Default rule allows Garland to pay diminution fee: they have no reason to bring it up, Peevyhouses don’t know Default rule forces Garland to do cleanup: if that’s inefficient, they could bring it up during negotiations In this case, specific performance would work as a penalty default