1. Econ 522 Economics of Law
Dan Quint
Fall 2016
Lecture 12

2. So far in contract law…
What types of promises should be binding contracts?
Breach of contract
Reliance
How liability for breach creates incentive for both, paradox of compensation
Hadley v Baxendale

3. Discussion question Old urban legend: Serious question:
A man bought a box of extremely rare and expensive cigars, and insured them against loss or damage.
After smoking them, he filed an insurance claim, saying they had been destroyed in 20 separate small fires.
The insurance company refused to pay, the man sued and won.
But as he was leaving the courtroom, he was arrested on 20 counts of arson.
Serious question:
If the intent of a contract is clear, but different from the literal meaning, which should be enforced?

4. Default Rules
Of course, Hadley and Baxendale could have made things much easier for the court – if they had just writing into the contract what should happen in case of delay
they could have signed a contract saying, Hadley agrees to pay X for shipping, and Baxendale will refund Y for each day of delay beyond the first
or they could have been even more specific
Baxendale agrees to ship by train
But then what happens if he learns the train schedule has changed, and shipping by boat becomes more practical?

5. 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 another buyer appears who wants the plane I’m building you
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 the airplane might not have addressed another buyer wanting it because I didn’t plan to show it to anyone else, and I had no idea someone else would see it
On the other hand, we could have imagined that it was at least possible for the price of raw materials 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.

6. Default rules
Gaps: risks or circumstances that aren’t specifically addressed in a contract
Default rules: rules applied by courts to fill gaps
One example: who bears the cost when performance becomes impossible?
I break my hand and can’t build you the airplane
So clearly, I don’t
But, do I owe you damages? Or am I excused from performing?

7. So, how should we fill these gaps?
Why are gaps left?
Because it wasn’t worth the cost to fill them
Normative Coase: design law to minimize transaction costs
In this case: make it “safe” to leave gaps in contracts
How to do this?
When there’s a gap in a contract…
…impute the rule the parties would have wanted, if they had chosen to think about this issue
What would the parties have wanted? Whatever was efficient!
Cooter and Ulen answer this question by going back to the Normative Coase view: the law should be structured to minimize transaction costs
One way to do this: make it “safe” for parties to leave gaps in contracts
How do we do this?
Make the default rule the rule the parties would have wanted, if they chose to negotiate over the issue
And what would the parties have wanted? That’s easy – whatever is efficient

8. Efficient contracts Example
A family hires a construction company to build a house
Risk a worker strike might cause a delay
1 in 50 chance of a strike
If company is responsible, they’ll have to pay for a hotel for the family, cost of $3,000
If not responsible, family can stay with friends, cost of $1,000
Expected cost is $60 if company bears it, $20 if family does
Efficient contract would make company not responsible
(If family was paying X for the house and company was liable for delay, BOTH parties would prefer a price of X – 40 and the company not being liable!)
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.)

9. Efficient contracts
Efficient contracts generally allocate each risk to whoever can bear (or prevent, or hedge) that risk at least cost
Sometimes called “low-cost avoider”
So, textbook argues: default rule should be to allocate risks that way
If something happens that wasn’t specified in the contract…
…figure out what efficient rule would have been…
…and allocate the loss to whoever the efficient contract would have allocated the risk!

10. Two complications Don’t want ambiguity in the law
Don’t want similar cases to be decided differently, since this would make contract law unpredictable
So default rule can’t vary contract by contract
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
If risk was unforeseen, might make sense to compensate party for bearing the risk
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

11. Who is the efficient bearer of a particular risk?
Friedman offers several bases for making this determination
Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Friedman offers several ways to figure out who this is
First: spreading losses
“Suppose I am having a house built by a large firm that builds many houses each year.
There is some risk that the house might burn down while it is being built.
We could allocate that risk either to me, by specifying that I will have to pay for the additional construction costs in such a case, or to the builder.
Since the builder is building many houses in different places, he can spread the risk; I cannot.
From that standpoint at least, our contract should specify a fixed price, whether or not something goes wrong.
If the contract does not specify who bears the risk, risk spreading provides an argument for assigning it to the builder.”
Second: who is in a better position to influence the outcome?
“In the case of a firm that builds houses the two arguments go in the same direction.
The builder is not only in a better position than I am to spread the risk, he is also in a better position than I am to keep the house from burning down while he is building it.”
(This is the argument that Baxendale should have borne the risk of a shipping delay – he’s the one who decided how to ship the broken crankshaft, so his actions influenced the outcome.)

12. Who is the efficient bearer of a particular risk?
Friedman offers several bases for making this determination
Spreading losses across many transactions
Moral hazard: who is in better position to influence outcome?
Adverse selection: who is more aware of risk, even if he can’t do anything about it?
“…The party with control over some part of the production process is in a better position both to prevent losses and to predict them.
It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”
For the third rule, Friedman gives the following question.
I promise to sell you 10,000 widgets; a drunk driver crashes into my factory, destroying half of them. I deliver them late, costing you money. Do I owe you damages?
“A third factor in allocating risk is adverse selection.
…I did not know that that particular drunk driver was going to crash through that particular wall.
But I probably do know a good deal more than you do about the chance that something – accident, strike, or bad planning – will prevent me from delivering the widgets to you on schedule.
If our contract makes me liable for the resulting loss, you don’t have to worry about that risk in deciding whom to buy your widgets from. You know what price I am charging, and you know that I am insuring you against the risk of nondelivery.
If the contract specified that you had to bear the risk, you would need to know the reliability of alternative sellers as well as their price in order to decide which one is offering the best deal.
“As this example suggests, moral hazard and adverse selection tend to cut in the same direction.
As a general rule the party with control over some part of the production process is in a better position both to prevent losses and to predict them.
It follows that an efficient contract will usually assign the loss associated with something going wrong to the party with control over that particular something.”

13. 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?

14. 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

15. 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.)

16. 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
Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules
Do this by imputing the terms most parties would have chosen if they had addressed this contingency
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.

17. Penalty Defaults

18. 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”
There’s also a very different take on default rules, in the article on the syllabus, “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules” by Ian Ayres and Robert Gertner
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
A penalty default would force him to disclose it
Which would likely be efficient

19. 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 holds Baxendale liable…
Hadley has no need to tell him the shipment is urgent
Baxendale doesn’t know and bad outcome is reached
If default rule doesn’t hold Baxendale liable for unforeseen damages…
Hadley would have to tell him about urgency…
…leading to Baxendale making more efficient choices (trading off cost vs speed/reliability correctly)
Even though it’s efficient for Baxendale to bear risk, efficient default rule might instead “penalize” Hadley for withholding 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 Baxendale bears the risk of delay, he internalizes the cost of his decision)
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 (which is exactly 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.)

20. Penalty defaults: example
Suppose…
80% of millers are low-damage – suffer $100 in losses from delay
20% of millers are high-damage – suffer $200 in losses from delay
Shipper liable for actual damages
Average miller would suffer $120 in losses
Shipper makes efficient investment for average type
But not efficient for either type
Shipper liable for foreseeable damages
Shipper makes efficient investment for low-damage millers
High-damage millers have strong incentive to negotiate around default rule
The book Game Theory and the Law (by Baird, Gertner, and Picker) has a nice analysis of the problem
“Let us assume that there are two types of millers. One type of miller is low-damage. In the event that the carrier fails to deliver the crankshaft on time, the low-damage miller suffers damages of $100. The other type of miller is high-damage and suffers $200 in damages when the carrier fails to deliver the crankshaft on time. The carrier knows that 20% of millers are high-damage and 80% are low-damage, but the carrier has no way of telling one type from the other.”
If miller was making the decision, high-damage millers would spend more to ensure prompt delivery
Consider rule where shipper is liable for actual damages. If there’s no way for shipper to figure out what type of miller he’s dealing with, the shipper knows that when there’s a delay, on average, he’ll owe $120.
So the shipper will choose efficient investment level for average case – that is, $120 in expected damages. So he spends inefficiently little for high-damage millers, inefficiently much for low-damage millers.
If the shipper is liable only for foreseeable damages, this would be $100; so he would spend efficient investment level for low-damage case.
This means the high-damage millers do badly – there’s an inefficiently high risk of delay, and they don’t get fully compensated if it happens.
But now high-damage millers have strong incentive to negotiate around the rule – basically, to buy insurance from shipper against delay. This would lead shipper to know who he’s dealing with, leading to efficient contracts for both types.

21. 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.

22. 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.

23. 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 argue that we need to look at why the parties left a particular gap
When gaps are left due to transaction costs of filling them, efficient defaults make sense
But 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.

24. When should a contract not be enforced?

25. When should voluntary trade not be allowed?
Going back to property law…
Coase Theorem: to get efficient outcomes, we should let people trade whenever they want to
But also saw some exceptions – some trades that aren’t, and shouldn’t, be allowed
Selling enriched uranium to a terrorist
Similarly with contract law…
First day: to get efficient outcomes, enforce any contract both parties wanted enforced
But next, we’ll see exceptions – contracts which shouldn’t be enforced, due to externalities or market failures/transaction costs

26. Example of an unenforceable contract: a contract which breaks the law
Obvious: contract to buy a kilo of cocaine is unenforceable
One example of an immutable rule: a contract to do something illegal is not enforceable
In some cases, this seems really obvious. I give you $25,000 in exchange for a promise to give me a kilo of cocaine. You take my money, give me nothing; I have no recourse through contract law.

27. Example of an unenforceable contract: a contract which breaks the law
Obvious: contract to buy a kilo of cocaine is unenforceable
Less obvious: otherwise-legal contract whose real purpose is to circumvent a law
Legal doctrine: derogation of public policy
Derogate, verb. detract from; curtail application of (a law)
Applies to contracts which could only be performed by breaking law…
…but also to “innocent” contracts whose purpose is to get around a law or regulation
But there are also less obvious situations, where a contract to do something perfectly legal on its face, is not enforceable, because the actual purpose of the contract was to circumvent the law
The legal doctrine here is derogation of public policy

28. Derogation of public policy – example
Labor unions required by law to negotiate “in good faith”
Recent NBA labor troubles
Old CBA: 57% of “basketball-related income” went to player salaries
Owners were offering less than 50%, players demanding 53%...
Imagine the following contract:
“For the next 50 years, if the NBAPA accepts a CBA paying less than 55% of BRI in player salaries, then we also agree that all non-retired players will work for you as coal miners every offseason at federal minimum wage.”
Purpose is purely to “bind hands” in negotiations with ownership
Contract would not be enforced
Collective bargaining agreement between players and team owners expired; owners have locked out the players (like an owner-initiated strike) until new agreement is reached
Negotiations are happening at the league offices in New York
Imagine during one of the off-days from negotiations, Derek Fisher, the president of the players union, drives down to Philadelphia, visits the owner of a coal mining company, and signs the following contract
There’s nothing illegal about a bunch of NBA players working as coal miners during the offseason
However, the purpose of this contract isn’t to actually do that – it’s purely to change the union’s bargaining position in its negotiations with the league
Once this contract is signed, Fisher can go back to the NBA offices in New York and say, “I don’t care what you say, there’s no way I can accept less than 55%”
But this would violate the union’s obligation to bargain in good faith, and so this type of contract would not be enforced.
(Also note for efficiency, we should be skeptical of contracts that impose externalities on people who aren’t parties to the contract…)

29. Derogation of public policy
In general: a contract is not enforceable if it cannot be performed without breaking the law
Exception: if promisor knew (and promisee didn’t)
I’m married, my girlfriend in California doesn’t know; I promise her I’ll marry her, she quits her job and moves to Madison
My company agrees to supply a product that we can’t produce without violating a safety or environmental regulation
Keeping either promise would require breaking the law…
…but I’d still be liable for damages for breach
Like in Ayres and Gertner: default rule penalizes better-informed party for withholding information

30. Default rules versus regulations
Talked earlier about default rules
Default rules apply if no other rule is specified…
…but can be contracted around
Rules like “derogation of public policy” cannot be contracted around
Parties to a contract can’t say, “even though this type of contract would normally not be valid, this one is”
Rules which always apply: immutable rules, or mandatory rules, or regulations
Fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying efficient default rules and regulations.

31. Ways to get out of a contract

32. Formation Defenses and Performance Excuses
Claim that a valid contract does not exist
(Example: no consideration)
Performance excuse
Yes, a valid contract was created
But circumstances have changed and I should be allowed to not perform without penalty
Most doctrines for invalidating a contract can be explained as either…
Individuals agreeing to the contract were not rational, or
Transaction cost or market failure
Next, I want to discuss a number of ways to get out of a contract, that is, conditions under which a contract will not be enforced.
These are typically divided into two categories: formation defenses and performance excuses
A formation defense is a claim that a contract does not exist: that the requirements for a contract to be valid were not met
(Under the bargain theory, for example, a formation defense might be that consideration was not given.)
A performance excuse is a claim that, even though a valid contract was created, circumstances have changed and you should be excused from performing
We said earlier that, under Coase, when individuals are rational and there are no transaction costs, voluntary negotiations should lead to efficiency
So refusing to enforce voluntary contracts would not make sense
Thus, most of the doctrines for invalidating a contract can be explained as a violation of one of these assumptions
either the individuals agreeing to the contract were not rational
or there was some sort of transaction cost or market failure

33. One formation defense: incompetence
Courts will not enforce contracts with people who can’t be presumed to be rational
Children
Legally insane
Incompetence
One party was “not competent to enter into the agreement”
No “meeting of the minds”
The first exception is that courts will generally not enforce contracts made by people who can’t be assumed to be rational. For example:
children cannot sign binding contracts
the legally insane cannot sign binding contracts
For example: this article (about a month old) is about 7-year-old who was messing around on eBay and hit the “buy it now” button for a decommissioned Harrier fighter jet selling for 70,000 pounds, or a bit over $100,000.
His father saw what he’d done and contacted the seller to apologize, and the seller, very reasonably, just re-listed the plane and sold it to another bidder
But if the seller had tried to hold the son to the deal, he would have failed
Contracts with children, and with the legally insane, can be invalidated under the doctrine of incompetence: one party to the contract was not competent to enter into a binding agreement
In fact, the law does not automatically invalidate all contracts made with children or insane people
It only invalidates contracts which were not in their best interests
(Basically, the law creates an incentive not to cheat people who can’t take care of themselves.)

34. So…
If courts won’t enforce a contract signed by someone who wasn’t competent…
What if you signed a contract while drunk?
You need to have been really, really, really drunk to get out of a contract
(“Intoxicated to the extent of being unable to comprehend the nature and consequences of the instrument he executed”)
Lucy v. Zehmer, Virginia Sup Ct 1954
The first time I taught this course, after I introduced the doctrine of incompetence, one of my students ed me an excellent question: what if you signed a contract while drunk?
Can a drunk person sign a legally enforceable contract?
or would the fact that he was drunk get him off the hook?
We mentioned that the bargain theory required a “meeting of the minds” to agree to a contract
It’s reasonable to question whether this could occur with someone who was drunk
However, the general rule in the U.S. is this:
You have to be really, really, really drunk for the contract not to count.
OK, that’s not how it’s written in the case law
The rule is, for a contract to be unenforceable, you need to have been “intoxicated to the extent of being unable to comprehend the nature and consequences of the instrument he executed.”
Basically, not just drunk enough to have bad judgment, but drunk enough to have no idea of what you’re doing
There’s a classic case that upheld this standard, Lucy v Zehmer, decided by the Supreme Court of Virginia in 1954
It’s a little embarrassing when your drunken antics end up in front of a state supreme court
But the case makes for really fun reading

35. Lucy v. Zehmer
Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time
While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”
“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”
The Zehmers owned a farm
Lucy had been trying to buy it from them for a long time
(They had made multiple offers, over several years, beginning at $20,000.)
One night, Zehmer’s out drinking, and he runs into Lucy
They continue to drink, and at some point, Lucy says something like, “I bet you’d sell that farm for $50,000.”
Zehmer says, “You don’t have $50,000.” Lucy says, “I can get it!”
Zehmer says, “No you can’t!”
They argue for a while about whether Lucy would be able to raise $50,000
And eventually Lucy says, “Write it down!”
Zehmer grabs a discarded guest check (seriously), turns it over, writes on the back, “We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,000, title satisfactory to buyer”
(It appears from the trial proceedings that there were two drafts. In the first, the name of the farm and the word “satisfactory” were both misspelled. Also, the first draft originally said “I agree,” to which Lucy pointed out that Zehmer’s wife co-owned the farm; Zehmer crossed off the “I” and wrote “We”)
So, Zehmer writes this contract and signs it; then he walks to the other end of the bar where his wife is sitting
He tells her to sign it, she says, “What?”
He whispers to her, don’t worry, it’s just a joke, we’re not selling the farm
So she signs it
He brings it back, Lucy takes the contract and puts it in his pocket

36. Lucy v. Zehmer
Zehmer and his wife owned a farm (“the Ferguson farm”), Lucy had been trying to buy it for some time
While out drinking, Lucy offers $50,000, Zehmer responds, “You don’t have $50,000”
“We hereby agree to sell to W.O. Lucy the Ferguson Farm complete for $50,00000, title satisfactory to buyer.”
That was Saturday. Sunday, Lucy calls his brother and gets him to put up half the money. Monday, Lucy goes to the registry of deeds to check the title, and then contacts Zehmer to carry out the contract
Zehmer claims he was drunk, and joking, and refuses to honor the contract
Lucy sues for specific performance, that is, asks the court to force Zehmer to sell him the farm at the agreed price
There was some dispute during trial about exactly how drunk Zehmer was
But it was ruled that while he was clearly drunk, he was not so drunk as to be “unable to comprehend the nature and consequences” of what he was doing
(For one thing, a little while later, his wife asked him to drive her home.)
Most of the opinion focuses on whether Lucy knew that Zehmer was joking when he wrote what looked like a proper, if unusual, legal contract
Zehmer claimed the whole thing was “a bunch of two doggoned drunks bluffing to see who could talk the biggest and say the most”
The court basically ruled that it wasn’t Lucy’s job to know Zehmer was joking
That is, Zehmer may have thought he was joking, but it looked to Lucy like he was serious
Zehmer behaved exactly as he would have behaved if he were drunk but actually wanted to sell the farm; which was good enough.

37. Lucy v. Zehmer
So, you can be pretty drunk and still be bound by the contract you signed
Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
You may think, being drunk, Zehmer lacked the necessary intent to enter into a contract
Still, it probably makes sense not to make it too easy to invalidate a contract on the grounds that one of the parties was drunk, or joking
If the ruling went the other way, it seems there would an awful lot of litigation over exactly how drunk someone was when a contract was signed
Not to mention a lot more contracts being signed in bars, to give the parties an easy way out
Or maybe a lot of lawyers carrying breathalyzers to make sure their contracts would be enforceable
Basically, a more nuanced rule would be extremely difficult and costly to enforce
So we seem to accept the cost of an occasional person making a bad decision while drunk, in order to keep the system working well the rest of the time.
However, that’s not quite the final word on drunkenness
If you were visibly drunk – that is, the other party clearly knew you were drunk – the court might be more willing to finding the contract unenforceable on other grounds (which we’ll get to shortly)
such as fraud (you were tricked into signing)
or unconscionability (the contract is too one-sided)
If Zehmer had agreed to sell the farm for $10, the contract probably would not have been upheld
But since the terms seemed reasonable, it was

38. Lucy v. Zehmer
So, you can be pretty drunk and still be bound by the contract you signed
Might think “meeting of the minds” would be impossible
But imagine what would happen if the rule went the other way
Borat lawsuits
Julie Hilden, “Borat Sequel: Legal Proceedings Against Not Kazahk Journalist for Make Benefit Guileless Americans In Film”
Moral of the story: don’t get drunk with people who might ask you to sign a contract
There’s also a more recent example of the doctrine that being drunk does not get you out of a contract: the Borat lawsuits
After the movie Borat came out a few years ago, two of the frat boys who ended up looking like racist a-holes sued
They claimed they were tricked into signing the releases agreeing to be in the movie
It seems the movie’s producers got them drunk and then asked them to sign the releases
And also lied to them a lot – saying the movie was only going to be released in Europe, they wouldn’t use the frat boys’ names, or college, or frat
Part of the problem for them is that the releases contained what are called “merger clauses”
Merger clauses basically say, it doesn’t matter what else we already told you, all we’re agreeing to is what’s in this contract
(Basically, any prior verbal agreement is “merged into” this contract, which is all we’re agreeing to.)
It’s kind of sneaky, but it does seem to legally absolve the producers of anything they told the frat boys to get them to sign but that wasn’t in the contract
Again, just being drunk doesn’t get you out of a contract
One of the fratboys seemed to find it relevant that he was under the drinking age; but that, if anything, would make the producers liable in criminal court (for supplying alcohol to a minor), but not invalidate the releases
(It’s also been established that the frat boys were all already heavy drinkers, unsurprisingly.)
Last I heard, the lawsuits have all been dismissed, and the frat boys got nothing.
(Since they’re not in the textbook; for the opinion in the Lucy v Zehmer case, which really does make great reading, see
For an overview of the legal issues in the Borat lawsuits, see a piece by Julie Hilden, with the brilliant title “Borat Sequel: Legal Proceedings Against Not Kazakh Journalist for Make Benefit Guileless Americans in Film” at
Moral of the story: don’t get drunk with people who might ask you to sign contracts.