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合同救济:一般理论
文/Paul G. Mahoney

 CONTRACT REMEDIES: GENERAL THEORIES

Abstract

This chapter surveys and analyzes the substantial literature on optimal remedies

for contract breach in a variety of settings. It begins with a standard analysis of

the behavioral effects of expectation and reliance damages, then discusses the

application of these damage measures in a world where courts are not perfectly

informed about the parties’ valuations of the contract. When valuation

problems are extreme, courts may turn to alternative remedies such as specific

performance, or parties may attempt to solve the problem themselves through

liquidated damages clauses. The chapter considers whether these solutions to

the valuation problem alleviate or exacerbate opportunistic behavior by the

parties. It also highlights the recent contributions that game theory and options

theory have made to the understanding of remedial choices.

JEL classification: K12

Keywords: Contract Damages, Remedies

 

1. Introduction

 

The principal remedy for breach of contract in Anglo-American law is an

award of money damages. The preferred measure of damages is the expectation

measure, under which the promisee receives a sum sufficient, in theory, to

make him indifferent between the award and the performance. Other damage

measures, and other remedies such as specific performance and rescission, are

available in special circumstances. This chapter discusses the basic design of

the remedial system.

 

A. The General Problem

 

2. Sanctions and Incentives

 

A contract is an exchange of promises or an exchange of a promise for a

present performance, and the parties enter into it because each values the thing

received more than the thing foregone. These values are based on expectations

about the future because some or all of the contractual performance will occur

in the future. When the future diverges from what a party expected, he may

conclude that the performance he will receive under the contract is no longer

more valuable than the performance he must provide. He has, in the

terminology of Goetz and Scott (1980), experienced a ‘regret contingency’ and

now would prefer not to perform and not to receive the promised performance

from the other party.

 

Absent a system of contract remedies, a party who regrets entering into a

contract will not perform unless he fears that the breach will result in sanctions

by the other party (who might have required security for the performance) or

by third parties (who might revise their opinion of the breacher and reduce their

economic and/or social interactions with him accordingly). The economic

function of contract remedies, then, is to alter the incentives facing the party

who regrets entering into the contract, which will directly affect the probability

of performance and indirectly affect the number and type of contracts people

make, the level of detail with which they identify their mutual obligations, the

allocation of risks between the parties, the amount they invest in anticipation

of performance once a contract is made, the precautions they take against the

possibility of breach, and the precautions they take against the possibility of a

regret contingency.

 

An administratively simple system of remedies would aim to reduce the

probability of breach to near zero. That could be achieved by the routine (and

speedy) grant of injunctions against breach backed by large fines for disobeying

the injunction or by imposing a punitively large monetary sanction for breach.

This would give promisees a high degree of confidence that the promised

performance will occur and induce a high level of investment in anticipation

of performance. In the standard parlance, this would be a ‘property’ rule

because it would entitle the promisee to the performance except to the extent

the promisor is able to negotiate a modification on terms acceptable to the

promisee.

 

3. Efficient Contracts and Efficient Nonperformance

 

Were it possible to enter into complete state-dependent contracts (that is,

contracts that identified every possible contingency (state) and specified the

required actions of the parties for each), parties would be willing to be bound

to contracts even were the sanction for breach punitive. Such contracts would

require performance in some states but excuse it in others, in such a way that

each party would be willing ex ante to be absolutely bound to perform the

required actions in all states. Shavell (1980) defines a ‘Pareto efficient complete

contingent contract’ as a complete state-dependent contract to which no

mutually beneficial modifications could be made, viewed at the time of

contracting. We will call such contracts ‘efficient’. In doing so, we will assume

unless otherwise stated that the parties are risk neutral, each party’s objective

is to maximize his wealth, post-contractual renegotiation is prohibitively costly,

performance is all or nothing (that is, partial performance is not possible), and

the contracts do not create uncompensated gains or losses for third parties.

 

Under what conditions would an efficient contract excuse performance?

Shavell demonstrates that the contract would require performance in all

circumstances except those in which nonperformance would result in greater

joint wealth. An example will illustrate the point. Imagine that Seller agrees to

manufacture and sell to Buyer a machine that Buyer will use in its own

manufacturing process. The value of the machine to Buyer is $300; however,

Buyer has an opportunity to make certain alterations to his manufacturing

plant, at a cost of $50, which will increase the value of the machine to $375.

Such investments by a promisee in anticipation of performance are called

‘reliance expenditures’ or ‘reliance investments’ in the literature, and we will

use the terms interchangeably. Assume for the moment that the future can be

represented as a set of two possible states; Seller’s production cost is $200 in

one state and $400 in the other. An efficient contract would require Seller to

make the machine in the low-cost state but not in the high-cost state. In the

high-cost state, the joint wealth of the parties is greater if Seller does not

perform than if it does. This can be seen by comparing the cost of performance

to Seller ($400) with the benefit to Buyer ($300 or $375, depending on whether

Buyer makes the reliance investment). The contract price is irrelevant as it is

transferred from Buyer to Seller and does not affect their joint wealth.

 

Both parties can be made to prefer this contract to one that requires

performance in both states. They can allocate between themselves the extra

wealth created by the efficient contract, and there will be some allocations

under which each party’s expected gain exceeds the expected gain from the

contract that always requires performance. By choosing such an allocation,

each party will be better off at the time of contracting and willing to be bound

to perform or not perform as required. In the literature, a breach that occurs in

circumstances in which an efficient contract would excuse performance is

called an ‘efficient breach’.

 

4. Barriers to Efficient Contracting; Remedies as a Substitute for

Efficient Contracts

 

To reiterate, faced with an efficient contract, courts would have the simple task

of requiring strict adherence to its terms. Unfortunately, the writing of efficient

contracts is no easy task. It is costly to bargain over remote contingencies and

the parties may lack the foresight to deal with all possible states. Moreover, the

parties may not have equal access to the information necessary to tell which

state occurs. In the above example, Seller may know whether the cost of

manufacturing the machine is $200 or $400, but Buyer may have no way to

verify Seller’s assertion.

 

Given these barriers to efficient contracting, the law faces a more complex

problem than that of compelling adherence to efficient contracts. Instead, it

must take incomplete contracts and augment them by damage measures that

induce behavior that mimics reasonably closely the behavior that an efficient

contract would require. A particular damage measure can be termed ‘efficient’

with respect to a particular decision if it creates an incentive for the relevant

party to make the same decision it would under an efficient contract. Because

standard damage measures allow a promisor to breach and pay compensatory

(rather than punitive) damages, they are called ‘liability’ rules in contrast to

property rules as defined above.

 

5. Other Approaches

 

An alternative framework for the design of damage measures is offered by

Barton (1972). He poses the problem as one of designing damage measures that

would induce the parties to make the same decisions regarding performance or

breach, and reliance prior to performance or breach, that they would make were

the parties divisions of a single, integrated firm and had the sole objective of

maximizing the value of the firm. Shavell and Barton each show that the

objective of an efficient regime of contract damages is to cause the parties to

maximize their joint wealth, although one might prefer Shavell’s conceptual

approach on the grounds that Barton’s assumes away the problem by positing

a wealth-maximizing firm.

 

A more recent perspective on contract damages is to consider money

damages as an option under which, for example, Seller may purchase Buyer’s

entitlement to Seller’s performance. The option expires on the date fixed for

performance and its strike price is the damage award (which may from the

parties’ perspective be a random variable). The value of the option is reflected

in the contract price (see Mahoney, 1995; Ayres and Talley, 1995). This

literature derives from the more general use of option theory to analyze decision

making under uncertainty (see Dixit and Pindyck, 1994). We will make

occasional reference to the options perspective below.

 

B. The Standard Damage Measures

 

6. A Taxonomy of Damage Measures

 

The preferred measure of contract damages is the amount of money that will

make the promisee indifferent between performance and damages. It should be

noted at the outset that this formulation of the measure of damages is not fully

accurate; there are a number of limiting doctrines, discussed in Chapter 4620,

that often reduce money damages below the promisee’s subjective valuation of

the performance. There is also some evidence that courts award greater

damages for breaches that appear opportunistic (see Cohen, 1994). As courts

express it, however, the preferred measure of damages is the amount necessary

to put the aggrieved party in the same position as if performance had occurred,

which is known as the expectation measure.

 

Fuller and Perdue (1935) provide the standard taxonomy of contract damage

measures. They identify three different ‘interests’ of the promisee that are

affected by a breach - expectation, reliance, and restitution - and state that the

most common damage measures provide compensation for one of the three. The

expectation interest is measured by the net benefit the promisee would receive

should performance occur, as described above. The restitution interest consists

of any benefit the promisee has provided the breaching party. For example, if

a seller agrees to make monthly deliveries of a commodity in return for fixed

payments due 60 days after each delivery and the buyer repudiates the contract

after receiving and retaining two deliveries but making no payments,

restitutionary damages would restore to the seller the value of the delivered

goods. The reliance interest is measured by the promisee’s wealth in the

pre-contractual position. Reliance damages provide compensation both for any

benefit conferred on the breaching party and for any other reliance investments

made by the promisee in anticipation of performance to the extent such

investments cannot be recovered.

 

In most instances, the restitution measure will provide the lowest recovery

and the expectation measure the highest. One complication is how to treat other

contractual opportunities that Buyer passed up in order to enter into the

contract with Seller. Analytically, these seem similar to reliance investments

and are often treated as such. In a competitive market, where Buyer could have

entered into another contract at an identical price had he not contracted with

Seller, the reliance measure and the expectation measure will converge

approximately. ‘Approximately’, because the value of the alternative contract

is a function of the probability that it will be performed (see Cooter and

Eisenberg, 1985) and of the damage remedy if it is not performed, and thus the

problem is somewhat circular. When analyzing the difference between

expectation damages and reliance damages below, we will assume that they

differ and that Buyer’s expectation interest exceeds his reliance interest. We

will also assume that the reliance interest equals or exceeds the restitution

interest, although we will relax that assumption in Section 12 below.

 

7. Incentives Within an Existing Contract: The Decision to Perform or

Breach

 

The expectation measure leads to efficient decisions to perform or breach an

existing contract, given a fixed level of reliance (see Barton, 1972; Shavell,

1980; Kornhauser, 1986). This can be illustrated using the example set out

above. Assume that the contract price for the machine is $250 and that Buyer

makes an irrevocable decision to invest $50 in reliance, an investment that has

no value absent the contract. When production costs are $200, Seller will

manufacture the machine and Buyer will pay $250 for it. Buyer then obtains a

machine worth $375 to him for a total expenditure (contract price plus reliance

expenditure) of $300. The transaction increases Buyer’s wealth by $75. When

production costs are $400, Seller will breach. The expectation measure seeks

to make Buyer as well off as if Seller had performed. Seller’s breach relieves

Buyer from his obligation to pay the contract price. Accordingly, if Seller pays

Buyer damages of $125, Buyer will be in the same position as if Seller had

performed, having paid out a non-recoverable $50 in reliance and received

$125, for a net increase in wealth of $75.

 

So long as Buyer is awarded $125 in the event of breach, Seller will breach

only when the cost of performance exceeds $375, the value of the performance

to Buyer. Compare this result to that obtained under the reliance measure.

Under the reliance measure, Seller must compensate Buyer for his $50 reliance

investment. Assume for a moment that there is a third possible state under

which Seller’s cost of production is $350. Performance would be efficient

because its value to Buyer exceeds its cost to Seller. Seller will perform given

expectation damages, because the damage award of $125 exceeds the net loss

from performance ($350 cost minus the $250 contract price). Given reliance

damages, however, Seller will breach and pay $50 rather than perform at a loss

of $100. More generally, it is obvious that given expectation damages, only

when the production cost reaches $376 will Seller become better off by

breaching and paying damages then by performing and losing the difference

between his production cost and the contract price. The expectation measure,

unlike the reliance measure, causes Seller to internalize fully the effect on

Buyer’s wealth of Seller’s decision to perform or breach.

 

8. Incentives within an Existing Contract: The Decision to Rely

 

While the expectation measure produces efficient decisions to breach given

reliance, it does not produce efficient levels of reliance. In general, expectation

damages result in excessive reliance expenditures, because they cause Buyer to

act as if performance were always forthcoming. In the example, Buyer will

always spend $50 to increase the value of performance from $300 to $375,

because either (1) the performance will be forthcoming or (2) Buyer will be

compensated for the lost $375 in value. In the high-cost state, however, the

parties’ joint wealth would be greater if Buyer refrained from investing. Seller

would be liable for damages of $300 less the $250 contract price, or $50. By

contrast, if Buyer relies, he receives $125 in damages as shown above and

increases his wealth by $75 net of the reliance expenditure. Unlike the

no-reliance case, where Buyer gains $50 and Seller loses $50, here Buyer gains

$75 and Seller loses $125. The difference reflects the fact that the $50

expenditure is wasteful in the high-cost state. Expectation damages, then, do

not cause Buyer to internalize fully the effect on Seller’s wealth of Buyer’s

decision to make a reliance investment.

 

The reliance measure is subject to the same objection. Under the reliance

measure, Buyer will recover $50 if it invests that amount in reliance. Once

again, Buyer’s investment decision will be made as if the investment is not

risky, even though it is (because performance is inefficient in some states).

Indeed, reliance damages create a perverse incentive for Buyer in some

circumstances. Assume for a moment that Seller’s production cost is $310.

Under the reliance measure, Seller will pay damages of $50 rather than perform

and suffer a loss of $60 ($310 minus the $250 contract price). Breach deprives

Buyer of a $75 gain (showing again that any measure of damages less than the

expectation measure induces inefficient breach decisions). Buyer may be able

to avoid breach, however, by making an additional (and we will assume

wasteful) reliance expenditure of $11. Now reliance damages amount to $61,

and Seller performs. Thus the excessive breach problem can be cured in part,

but at the cost of excessive reliance. In general, as Shavell (1980) demonstrates,

the reliance measure will result in greater (inefficient) reliance expenditures

than the expectation measure. There is no measure of damages that results both

in efficient decisions to perform or breach and efficient decisions to make or not

make reliance expenditures. However, expectation damages do better than

reliance damages at inducing efficient breach decisions, and do no worse than

reliance damages at inducing efficient reliance decisions. Accordingly, given

the various assumptions outlined above, the expectation measure is preferable

on efficiency grounds.

 

The analysis to this point has assumed risk neutrality. A risk-averse Buyer

would have additional cause to prefer the expectation measure, because it

eliminates variability from Buyer’s outcome. At the same time, the expectation

measure introduces greater variability into Seller’s outcome than does the

reliance measure. It is accordingly possible that where both parties are risk

averse, they may find that a sum of damages greater than the reliance measure

but less than the expectation measure offers the highest joint utility level. The

precise formulation of the damage amount would depend on the parties’

comparative levels of risk aversion (see Polinsky, 1983). It seems plausible that

courts have not tried to alter damage measures to accommodate risk aversion

(except to the extent specific performance can do so, as discussed in Section 10

below) because of the administrative and error costs that would result.

 

The analysis has also assumed that renegotiation at the time of breach is

prohibitively costly. Were negotiation costless, the damage rule would be

irrelevant, as the parties would in all cases bargain to Pareto efficient

breach/performance and reliance decisions, as per the Coase Theorem (Coase,

1960). In the more plausible situation where renegotiation is costly but not

always prohibitively so, the choice of remedy is necessarily more difficult.

Some critics have therefore argued that much of the literature on damage

remedies is beside the point, as the choice of remedies should be informed

principally by an analysis of transaction costs (see Friedmann, 1989; MacNeil,

1982). Friedmann analyzes potential transaction costs in a variety of

contractual settings and argues that over compensatory remedies (remedies that

provide compensation to the promisee in excess of the expectation interest) will

generally be efficient.

 

9. Incentives at the Stage of Contract Formation

 

Friedmann and MacNeil are surely correct to argue that a better understanding

of the costs of postcontractual renegotiation is necessary for making efficient

remedial choices. It is also, however, worth paying attention to the effect of

remedies on precontractual negotiations.

 

The price Seller will require to enter into a contract is increasing in the

damage measure. Returning to our example, when Buyer makes a $50 reliance

expenditure and Seller breaches, again assuming no opportunity costs, Buyer’s

wealth decreases by $50. Buyer can be no worse off from entering into the

contract so long as the remedy for breach is at least $50. Will Buyer be willing

to pay more for the more generous expectation measure, and will Buyer and

Seller prefer the resulting contract to one that provides for reliance damages

only? As Friedman (1989) notes, the difference in remedies affects the contract

price, the quantity contracted, and the quantity actually consumed, with effects

that vary with market structure and utility functions. In general, however, the

range of contract prices for which the contract increases both parties’ wealth

will be greater under a reliance measure than an expectation measure. That is,

the reliance measure will create a greater bargaining range, which might

increase the number of contracts entered into.

 

The choice of remedies where precontractual as well as postcontractual

incentives are analyzed remains an underdeveloped area. Friedman (1989)

provides a formal analysis of expectation and reliance for two contexts in which

those measures diverge. The first is the case of a breaching buyer who has

contracted to purchase from a monopolist selling at a single price. The second

is the case of a breaching buyer in a competitive market where the seller does

not know its production cost in advance but the buyer does. Friedman

demonstrates that neither damage remedy dominates the other under those

conditions. Friedman’s analysis is limited, however, by his assumption that

reliance is fixed and exogenous. The situations he analyzes, moreover, have the

desired formal characteristics (expectation and reliance measures diverge) but

are probably not very common.

 

A possible alternative would be to start by assuming that the expectation

and reliance measures diverge without specifying market structure in detail. A

model could then be developed in which the choice between expectation and

reliance damages affects the structure of the contract, the decision to breach,

and the decision to rely. The equilibrium and comparative statics of such a

model might shed light on the type of market conditions under which

expectation or reliance damages would be more nearly optimal. It would also

be valuable to consider carefully whether there are plausible conditions under

which the cost of negotiating around an inefficient damages measure at the

time of contracting is greater or less than the cost of renegotiating at the time

of performance.

 

C. Alternative Damage Measures

 

10. Specific Performance

 

Disappointed promisees are not in all cases limited to an award of damages;

under appropriate circumstances, they may seek the equitable remedy of

specific performance. A decree of specific performance requires the breaching

party to perform according to the contract. The principal criterion for awarding

specific performance is a demonstration that money damages are insufficient

to compensate the promisee for the lost performance. Traditionally, this was

most often found when the breaching party was a seller who had agreed to sell

a ‘unique’ good. Real estate has long been presumed in many jurisdictions to

be unique, while other goods such as artworks and heirlooms are often found

to be unique.

 

Specific performance is analogous to a punitive sanction that seeks to deter

breach absolutely. In order for it to have that effect, we must assume that

renegotiation is costly. It would then seem clear that expectation damages are

preferable to specific performance, because the latter would sometimes result

in performance even though nonperformance would result in greater joint

wealth. On the other hand, it should be clear that the assumption that courts

can adequately calculate a sum of money sufficient to make the promisee

indifferent between damages and breach is not always accurate, particularly

where cover is not possible. In such circumstances we must rely on a lost

surplus measure of damages, and the calculation of Buyer’s consumer surplus

is necessarily subjective. This is not a fatal objection if we believe that courts

will guess correctly on average, but if they systematically underestimate Buyer’s

surplus, the monetary remedy will result in too much breach, just as specific

performance results in too much performance.

 

Kronman (1978) started the law and economics debate on specific

performance by employing a framework similar to that of the prior paragraph.

He notes that specific performance is a property rule in the sense defined in

Section 2 above; it effectively assigns the promisee an absolute entitlement to

the goods from the moment the contract is made. This does not make sense in

most instances because renegotiation (meaning a transfer of the property right

back to the promisor) is costly and the result will be an inefficiently high level

of performance. The danger of undercompensation, which would result in an

inefficiently low level of performance, is normally lower because there is often

a substitute price available. When, however, there is no substitute price

available (the case of ‘unique’ goods), the danger of under compensation likely

outweighs the cost of renegotiation. Accordingly, the legal rules, in a rough

manner, promote efficiency.

 

Schwartz (1979) argues that undercompensation is not merely an isolated

problem limited principally to goods for which there is no obvious substitute,

but is built into the structure of money damages. The reluctance of courts to

award damages that are uncertain, difficult to measure, or unforeseeable (see

Chapter 4620), or to provide compensation for emotional harm resulting from

a breach, makes money damages systematically under compensatory. Schwartz

argues that the resulting inefficiencies are likely greater than those resulting

from renegotiation costs, and accordingly that specific performance, rather than

money damages, should be the default remedy.

 

Bishop (1985) adopts a similar analytic approach but argues that both

Kronman and Schwartz have overgeneralized their arguments. He breaks down

contract breaches into a number of categories depending on the identity of the

breaching party (buyer or seller), the type of contract, and the alternative

transactions available to buyer and seller. He also identifies another cost of

awarding specific performance. Because the value of a specific performance

award (including the amount the promisor will pay to be released from

performance) will in some cases exceed the value of performance to the

promisee, the promisee will be tempted to behave opportunistically in hopes of

causing a breach and satisfying the conditions for specific performance. Bishop

argues that in some categories the problem of excessive breach resulting from

undercompensation will dominate, and in others the problem of excessive

performance resulting from renegotiation costs and opportunism will dominate.

 

The relative magnitudes of the inefficiencies generated by costly

renegotiation and undercompensation are ultimately empirical questions and

to date the literature does not provide data from which we could confidently

identify the preferred remedy. Accordingly, Mahoney (1995) takes a different

approach to the problem, using the option methodology outlined above. The

methodology is first employed to confirm the argument made by Craswell

(1988) that were renegotiation costless and money damages perfectly

compensatory, risk-averse contracting parties would always prefer money

damages to specific performance. The intuition is that entering into a contract

with a money damages remedy is analogous to holding a hedged position in a

commodity, whereas the identical contract with a specific performance remedy

is analogous to holding an unhedged position. The variance of possible

outcomes is greater for both parties with the unhedged contract and they will

accordingly prefer money damages. In the face of costly renegotiation and

undercompensation, we can still make some sense of the case law using the

option heuristic. Many contracts involving ‘unique’ goods are prompted by the

desire of the buyer to speculate on the future value of the land, artwork, and so

on, and speculation involves holding an unhedged position. Thus buyer and

seller would likely prefer specific performance. Other cases in which specific

performance has been consistently awarded (long-term contracts to supply a

fuel input to a public utility or other regulated entity) can be explained by

noting that the buyer is likely more risk averse with respect to price fluctuations

than is the seller, and specific performance better accommodates that

distinction.

 

11. Liquidated Damages

 

We began the analysis of damages by arguing that court-awarded damages

function as a substitute for complete state-dependent contracts. The court’s

application of an efficient damages rule creates appropriate incentives to

perform or not perform, rely or not rely, and so on, and thereby saves the

parties the trouble of drafting their contract to provide for all contingencies.

Some parties, however, choose to create a tailor-made incentive structure

by specifying the amount of damages payable in the event of breach. Courts

have adopted a skeptical attitude toward these so-called liquidated damages

clauses. In general, courts will enforce a liquidated damages clause only if (a)

at the time of contracting, the damage that the promisee will suffer in the event

of breach (that is, the promisee’s expectation) is uncertain, and (b) the amount

of liquidated damages is both a reasonable estimate of (the mean of) those

damages and not disproportionate to the actual (ex post) damages. A larger

amount is called a ‘penalty’ and is unenforceable.

 

This attitude is puzzling to most law and economics scholars. Absent some

reason to believe that one or both parties misunderstood the terms of the

agreement, we would normally assume that they went to the trouble to specify

liquidated damages because the resulting contract is Pareto superior to a

contract that calls for the ordinary court-awarded damages. The courts’

approach might increase the net wealth of the parties, but only if the existence

of a penalty is strong evidence that the contract does not represent the parties’

actual intent, perhaps because one defrauded the other. The focus of scholarship

in the area, therefore, has been to ask under what circumstances rational,

well-informed parties would agree to a penalty clause.

 

Goetz and Scott (1977) note, in terms similar to those of the later specific

performance debate, that damages measures do not adequately compensate for

the subjective value the promisee attaches to performance, particularly when

close substitutes for the performance are unavailable or the timing of the

performance is critical. In those circumstances, normal damage measures will

lead to excessive breach.

 

The promisee could purchase third-party insurance that would pay off in the

event of breach in an amount sufficient to make him whole. In some

circumstances, however, the probability of breach is determined not just by

exogenous variables beyond the parties’ control, but also the level of care taken

by the promisor. For example, a delivery service can affect the probability of

timely delivery by the level of care it takes with the package. In such

circumstances, the promisor can insure more cheaply than a third-party because

the promisor can alter its level of care in response to the insurance clause. In

other circumstances, the promisor may be better informed about the probability

of breach than a third-party insurer. The delivery service, for example, may be

better informed than the promisee or any third-party insurer about the

breakdown rate of its trucks. In such cases, the promisor can use its willingness

to agree to a penalty clause as a means of credibly signaling a low probability

of breach.

 

It is accordingly not true that the mere existence of a penalty clause is a

strong indicator of fraud or mistake; there are plausible conditions under which

a penalty clause would make both parties better off. Schwartz (1990)

supplements this analysis by considering the effects of a penalty clause on

pre-contractual incentives. He notes that the price that the promisor will charge

is increasing in the damage measure. To the extent promisees insist on

inefficiently large penalties, therefore, they will either pay too much or enter

into too few contracts. The promisee accordingly has an incentive to demand

a penalty clause only when it would increase the joint wealth of the parties.

 

Other commentators have argued that penalty clauses can create

externalities. Aghion and Bolton (1987), for example, demonstrate that a

supply contract containing a penalty clause for buyer’s breach can restrict entry

by competing sellers. We might at first conclude that buyer would have no

incentive to agree to a contract that limited competition from other sellers. A

well-designed penalty, however, will merely redistribute wealth from the new

entrant to the contractual buyer and seller. To see why, assume a contract

between Buyer and Seller with a contract price of $200, and Seller’s cost of

performance is $150. At a later time, Entrant appears, who can provide the

good for $100. Seller’s expectation damages will be $50, so absent a penalty

Buyer can profitably breach if Entrant offers a price of $149 or less. Assuming

that Entrant does not face competition, Entrant will demand a price of $149.

Now imagine that Buyer must pay a penalty of $80 upon breach. Now it is not

profitable for Buyer to breach unless Entrant offers a price of $119 or less.

Entrant can still profitably sell at that price, and will do so. Thus the penalty

transfers wealth from Entrant to Seller (which Seller can agree ex ante to share

with Buyer).

 

Aghion and Bolton’s analysis works only if Entrant has market power. The

externality arguments for the most part are not sufficiently general to provide

a compelling explanation for the judicial hostility toward penalty clauses.

Moreover, while they can provide support for part of the judicial approach

(disallowing liquidated damages that are not a fair ex ante estimate of actual

damages), they cannot explain the failure to enforce liquidated damages that

are excessive ex post.

 

12. Rescission/Restitution

 

Courts divide contract breaches into ‘partial’ and ‘total’ breach. A partial

breach gives the promisee the right to seek a remedy but not to refuse his own

performance. The classic example is when a builder constructs a house that

contains a minor deviation from the agreed architectural plan. The builder must

compensate the owner for the difference in value (in theory, the difference in

subjective value to buyer, but it will usually be difficult to convince a court that

this differs substantially from the difference in market value). The owner may

not, however, refuse to accept delivery of the house and to pay the agreed price.

A total breach, by contrast, permits the promisee to refuse to render his own

performance. In effect, a total breach permits the promisee to rescind the

contract.

 

As courts express it, a promisee can respond to a total breach by seeking

expectation damages or by rescinding and seeking recovery of any value he has

provided to the breaching promisor. The latter alternative is equivalent to the

restitution measure of damages (although in some circumstances the promisee

may seek return of the performance in specie rather than its monetary

equivalent). Restitution is also a remedy in quasi-contractual situations, such

as when parties partly performed a contract that is voidable for mutual mistake,

but the following discussion will be limited to restitution damages as a remedy

for breach.

 

In the typical case, expectation damages will exceed restitutionary damages

and the promisee will seek the former. There are two instances, however, in

which we would expect the promisee to seek the latter. The first is when the

promisee is risk averse and prefers the certainty of the return of money or

property that he has given the promisor to the uncertainties of a jury’s

assessment of his expectation and the additional litigation costs that would be

incurred in the attempt. The second is when the contract was a losing deal for

the promisee, so that his expectation is negative. Where the promisee has

provided something of value to the promisor that cannot be easily returned, but

can be valued in a judicial proceeding, the promisee may be better off receiving

that value in cash than receiving the promised performance.

This might be thought a remote possibility, but it occurs in a number of

reported cases. The textbook example is one in which a builder agrees to build

a house for an owner and the builder’s costs turn out to be greater than

expected, making the contract a losing one for the builder. The owner,

however, later decides it does not want the house and repudiates the contract

when the house is partly completed. The builder’s expectation is negative

because of the unexpectedly high costs of construction, so the builder seeks

restitution. Restitution in this instance is measured by the value the builder has

conferred on the owner, or the market value of the nearly-completed house. By

hypothesis, this exceeds the contract price.

 

When promisees have attempted to recover reliance damages for a losing

contract, courts have concluded that the expectation measure puts an upper

bound on the recovery (see L. Albert & Son v. Armstrong Rubber Co.). By

contrast, some courts have permitted a promisee to recover restitution damages

in excess of expectation (see Boomer v. Muir). This seeming inconsistency has

been largely ignored in the law and economics literature. The most useful

discussions appear in a symposium issue of the Southern California Law

Review in 1994. In it, Kull (1994) provides an analysis of restitution that is

similar in many respects to Bishop’s analysis of specific performance. Money

damages are not always an adequate substitute for performance and the damage

calculation is in any event uncertain. Thus where the promisee has provided

something of value to the promisor that can easily be returned, the promisee

may prefer to rescind the transaction, putting both parties back in the

pre-contractual position. For example, the promisee may have paid in advance

for a good or service that the promisor fails to provide. Taking litigation costs

into account, the promisee may prefer to rescind the transaction and retrieve the

advance payment.

 

One example of a situation in which it seems likely that rescission and

restitution will minimize the costs associated with breach is where a seller

delivers goods that do not conform to the contractual specifications. The perfect

tender rule, recognized under the common law and the Uniform Commercial

Code, permits a buyer to reject nonconforming goods even if the variation is

minor. As noted by Priest (1978), the administrative costs involved in

calculating the difference in value between the goods as delivered and as

promised will likely exceed the cost of returning the goods to Seller and money

to Buyer. The costs associated with salvaging the nonconforming goods might

also be minimized by the perfect tender rule, as in many instances it will be

cheaper for Seller to find another purchaser for the goods than it will be for

Buyer to adapt the goods to Buyer’s own use.

 

On the other hand, where the contract is a losing one for the promisee and

the promisee has conferred a benefit on the promisor that cannot easily be

returned, the remedy of rescission and restitution is potentially over

compensatory. Kull argues that the threat of opportunistic behavior (that is,

socially wasteful efforts to exploit an inefficient remedy to obtain an

unbargained-for benefit) will be substantial for such contracts. The promisee

can turn a loss into a gain by inducing breach by the promisor (or convincing

a court that mutual uncooperativeness constituted or resulted from such a

breach). By contrast, the perfect tender rule permits a buyer to behave

opportunistically by unreasonably claiming that goods are defective when their

market value has declined, but because the goods can be returned to Seller, the

parties are spared the additional cost of a court proceeding to determine their

value.

 

D. Calculation of Expectation and Reliance Damages

 

13. A Categorization of Approaches to Calculating Damages

 

There is consensus that the expectation measure is in most circumstances

superior to reliance or restitution damages. A separate but no less important

question is how expectation and reliance are to be defined and measured in

typical contractual settings. Parties’ valuations are often unknown to one

another and to the court, and promisees have an incentive to overstate their

valuations, making the calculation of expectation damages difficult in some

settings. Cooter and Eisenberg (1985) present a very helpful categorization and

analysis of alternative calculation methods. They identify five broad categories

and note that the calculation of money damages in reported cases usually falls

into one of these categories. They are:

 

(i) Substitute Price. Often there is a spot market for the contractual performance

at the time and place that performance was due, most obviously if the

performance consists of the delivery of a marketable commodity. In such an

event, Buyer can respond to Seller’s breach by cover, or the purchase of the

commodity on the spot market. (Seller can respond to a breach by Buyer by

selling on the spot market.) The difference between the contract price and the

price at which cover occurred or could have occurred is then a measure of the

cost of making Buyer (or Seller) indifferent between the contract and the

substitute performance. We should note, however, that the substitute price

measure can be overcompensatory when a promisee chooses not to cover but

instead to sue for the difference between the contract price and the spot price.

That choice itself suggests that the promisee may value the commodity at less

than its market price.

 

(ii) Lost Surplus. When cover is unavailable, Buyer’s expectation can be

thought of as the lost consumer surplus from the contract. In our ongoing

example, if Buyer cannot cover, he loses the difference between his valuation

of the machine ($300 or $375, depending on reliance) and the $250 contract

price. The analysis of Seller’s lost producer surplus from Buyer’s breach is

analogous. The lost surplus measure is feasible only when a court can obtain

credible evidence of the promisee’s valuation.

 

(iii) Opportunity Cost. If a market exists for the performance, Buyer could have

entered into a contract to buy the machine from any one of a number of

competing sellers. The value to Buyer of the best alternative contract available

at the time of the contract with Seller is an important component of his

reliance. This value cannot be measured objectively because Buyer did not enter

into this hypothetical contract and we do not know whether the hypothetical

contractual party would have performed. Assuming that the probability of

performance of the alternative contract is high, however, then the difference

between the spot price at the time and place of breach and the price of the

foregone contract is a good measure of reliance (augmented by any

out-of-pocket expenditures in reliance on the contract with Seller). In a

competitive market, the next-best price and the contract price should be the

same, and the opportunity cost measure will equal the substitute price measure

(a conclusion consistent with Fuller and Perdue’s conclusion that expectation

and reliance damages are equal in a competitive market).

(iv) Out-of-Pocket Cost. This is the amount of reliance investment, less any

salvage value of that investment. Out-of-pocket cost is the most common

measure of reliance damages; a more complete measure of reliance damages is

out-of-pocket cost plus opportunity cost.

 

(v) Diminished Value. So far we have ignored partial performance. In the real

world, however, performance is often rendered but is defective or incomplete.

In such cases an appropriate measure of Buyer’s lost expectation is the

difference between Buyer’s valuation of the promised performance and his

valuation of the actual performance.

 

As these alternative methods of calculation should make clear, the measure

of damages is usually straightforward and uncontroversial where cover is

possible. The accepted measure of damages in such cases is the difference

between the cover price and the contract price, which is easy to apply and

provides appropriate incentives regarding the decision to perform or breach.

The difficult questions arise when there is no perfect substitute for the

performance (or there is room for debate about whether the substitute is

adequate) or where the manner or timing of the breach causes harm that cannot

be remedied by cover. We will provide two examples of cases that arise

frequently and that have been the much discussed in the literature, in which

there is debate over the appropriate means of measuring the non-breaching

party’s expectation.

 

14. Example 1: Anticipatory Repudiation

 

Common law judges and scholars initially found anticipatory repudiation - a

definitive statement by a promisor, made prior to the time for performance, that

he intended to breach - extraordinarily vexing. Some concluded that any such

statement must be without legal effect; the performance was due on a particular

date and breach could therefore only occur on that date (Williston, 1901).

Courts eventually came to the view that the promisee could treat the repudiation

as a breach (Hochster v. De La Tour), but found it more difficult to decide how

damages should be measured. The most famous early case, Missouri Furnace

v. Cochrane, held that the appropriate measure was the difference between the

contract price and the spot price at the time specified for performance. The

Uniform Commercial Code, by contrast, encourages prompt cover, presumably

in the futures market. As noted by Jackson (1978), the legal literature on

anticipatory repudiation from the early part of this century is voluminous.

 

Jackson argued that in applying the Uniform Commercial Code’s provisions

on cover to anticipatory repudiation, courts should fix damages at the difference

between the contract price and the futures price at the time of repudiation. He

noted that the Missouri Furnace method is systematically overcompensatory.

Imagine, for example, that Seller breaches a contract to supply a commodity in

the future and that the spot and futures prices at the time of repudiation are

higher than the contract price. Over a large number of contract breaches,

however, the spot price at the time of performance will sometimes be higher,

and sometimes lower, than the contract price (in present value terms).

Whenever it is lower, Buyer will not bring a damages action because he has

been made better off by the breach. He is under no obligation to share this gain

with Seller. When the spot price is higher than the contract price, Buyer will

recover the difference between the two. Averaged over a large number of

contracts, buyers in the aggregate receive more than would be required to make

them as well off as they were under the contract. Awarding the difference

between the contract price and the futures price, by contrast, puts each buyer

in the position he occupied prior to the repudiation and at a lower average cost

to sellers.

 

We might simplify Jackson’s argument by noting that the Missouri Furnace

rule replaces a forward contract by an option with a strike price equal to the

forward price. Because the value (prior to expiration) of an option with a strike

price of X is always greater than the value of a forward contract with a contract

price of X, the Missouri Furnace damage measure is overcompensatory.

 

15. Example 2: The Lost-Volume Seller

 

Sellers in a competitive market have often argued that the Substitute Price

measure of damages, which awards them the difference between the contract

price and the spot price, is undercompensatory. In many instances, there is little

or no difference between the contract price and the spot price, and accordingly

the damage award is trivial. Sellers contend, however, that they are not ‘made

whole’ by selling in the spot market; the seller had the capacity to sell to both

the substitute buyer and the original buyer at the market price, and the breach

reduced their sales volume by one unit. Thus in place of two sales and two

profits, they have received only one sale and one profit. Courts have often

awarded the so-called ‘lost-volume seller’ an amount of damages equal to its

ordinary profit on one sale. In the well-known case of Neri v. Retail Marine

Corp., Retail Marine, a dealer in boats, agreed to sell a boat to Neri at a fixed

price. Retail Marine ordered the boat from the manufacturer but Neri

repudiated the contract. Retail Marine sold the boat to another customer for the

same price and successfully sued Neri for the profit it would have made on the

sale to him. The court concluded that Retail Marine, as a dealer, had an

‘inexhaustible’ supply of boats, and Neri’s breach deprived it of a profitable

sale.

 

There is a substantial law and economics literature on the lost-volume

seller. An early contribution appeared in an anonymous student-written

comment (Anonymous, 1973). The comment noted that in a perfectly

competitive market, each seller would choose output by equating marginal cost

with demand and the demand curve would be presumed horizontal. At the

chosen output, the firm’s marginal cost would be rising and therefore any

additional sale would be at a cost in excess of the price. Because the seller could

not, in fact, satisfy additional buyers at the market price, the breach and resale

would create no ‘lost volume’ in a perfectly competitive market. A seller with

market power (that is, one facing a downward-sloping demand curve) might be

able to make additional sales at a profit. However, by hypothesis, such a seller

could eliminate the ‘lost volume’ by reducing its price and making an

additional sale. Thus the standard contract price minus cover price measure

would fully compensate such a seller.

 

Goetz and Scott (1979) provide an additional argument against awarding

lost profits to the retailer who has market power. They note that the breach

removes the breaching buyer as a competing seller. The buyer presumably

breaches because it no longer wants the good at the contract price. In lieu of

breaching, however, the buyer could complete the purchase and then resell the

good. This resale, if made in the same market in which the retailer operates,

shifts the demand curve facing the retailer to the left by one unit. Once again,

if we compare the retailer’s position after the breach to its position assuming

no breach but resale by buyer, there is no lost volume.

 

Goldberg (1984) disputes Goetz and Scott’s analysis. He first argues that the

observation that a non-breaching buyer could sell in competition with the

retailer is unrealistic. In fact, he argues, the buyer, lacking expertise, would

have to engage the services of a retailer. The retailer’s usual markup is a

reasonable estimate of the fee the retailer would charge for his services.

Accordingly, the award of lost profit to the retailer approximates the result that

would obtain if the buyer purchased and resold.

 

Goldberg also argues that it is inaccurate to say that the retailer ‘saves’ the

marginal cost of a sale when the original buyer breaches and then incurs that

marginal cost when the substitute buyer appears. He contends that the retailer’s

cost of servicing an additional buyer consists principally of the cost of ‘fishing’

for a buyer, or convincing the marginal buyer to purchase (represented,

perhaps, by costs of advertising, wages paid to salespeople, and so on). That

cost is irretrievably lost once a contract is concluded with the original buyer and

must be incurred again in order to induce another buyer to purchase. More

recently, Scott (1990) argues that Goldberg’s equation of marginal cost with the

cost of ‘fishing’ is inaccurate; for some goods, the cost of delivery and

preparation for delivery are significant, and those costs are not incurred twice

when a buyer defaults. Cooter and Eisenberg (1985) provide an analysis similar

to Goldberg’s, but focus on the seller with market power. They argue that many

sellers hold price at a constant level reflecting expected demand and marginal

cost over some period, rather than constantly adjusting price to reflect realized

demand. Such sellers can lose volume in a particular period.

 

Goldberg also notes that consumer demand is decreasing in the damage

measure. Accordingly, were the legal rule to shift suddenly from a substitute

price damages measure to one awarding lost profits, the demand curve facing

the retailer would shift downward, offsetting the benefit of the higher damage

awards. Whether consumers and producers would prefer the resulting contract

to one that provides only substitute price damages again depends on

comparative levels of risk aversion.

 

It appears that the literature on the lost-volume seller is at an impasse. The

identification of the best damages rule turns on complex and contestable claims

about market structure. A better avenue of inquiry would be to pay attention to

actual contractual practice. Many sellers of custom goods require

non-refundable deposits, which in effect contracts for a lost-profits measure.

Other sellers (such as many computer retailers) permit a buyer to return an item

for a full refund for some period after delivery, which in effect contracts for an

even more lenient approach than the substitute price measure. It seems likely

that greater ground will be gained by empirical analysis of the characteristics

of markets in which varying cancellation/return policies are used than by

further refinements of the theoretical arguments.

 

E. Conclusions

 

16. The Puzzle of Overcompensatory Remedies and Some Suggestions

for Further Research

 

Most of the prior analysis could be summed up as follows: when courts and

contracting parties are well-informed about each party’s valuation of the

contract, money damages measured by the promisee’s valuation (or

expectation) provide reasonably good incentives for efficient pre- and

post-contractual behavior. Problems arise, however, when there are significant

informational asymmetries between the parties and/or between each party and

the court. Such asymmetries raise two pervasive issues in contract law. The first

is subjective value. The existence of potentially over compensatory remedies

such as specific performance, liquidated damages and restitution can be

attributed to judicial recognition that money damages measured by the

promisee’s expectation will sometimes undercompensate, because courts use

objective indicators of value that may diverge from the promisee’s subjective

valuation. Only a few brief attempts have been made, however, to explore

subjective value as a unifying theme in contract remedies (see De Alessi and

Staaf, 1989; Muris, 1983).

 

The second issue is opportunism. The possibility that a remedy, although

designed to be perfectly compensatory, will in fact undercompensate (overcompensate)

may encourage the breaching party (non-breaching party) to use

the defect in the remedy to gain bargaining leverage over the other party. The

risk of opportunism is the likely reason why courts have not responded to the

problem of subjective valuation by instituting overcompensatory remedies

across the board.

 

A worthwhile avenue for additional work would be a careful comparison of

the ways in which courts have or have not managed to reduce the risk of

opportunism across a range of remedial choices. A promising approach to this

question appears in the liability rule versus property rule literature. When

neither party knows the other’s true valuation of the contract, each has an

incentive to over- or understate his valuation in an attempt to capture as much

as possible of the gains from contract modification or cancellation. The result

is to make agreement more costly. The costs imposed by asymmetric

information, which we will call ‘bargaining costs’, are a subset of the cost of

reaching a deal. The key question is whether the choice of remedy affects

bargaining costs.

 

A specific application to liquidated damages is offered by Talley (1994). He

uses the mechanism design branch of game theory to analyze the effects of

different enforcement rules on bargaining costs, concluding that enforcement

of liquidated damages that exceed actual damages ex post creates significant

bargaining costs. By refusing to enforce penalty clauses, courts may make it

more likely that the parties will bargain to an efficient outcome. The argument

is unique in offering a plausible economic justification of the ex post

component of the liquidated damages rule.

 

Ayres and Talley (1995), employ game theory to argue that bargaining costs

are generally lower under liability rules than under property rules. The intuition

is as follows. Going back to our contract between Seller and Buyer, imagine

that Seller wishes to breach, and believes Buyer’s valuation of the contract to

be uniformly distributed on the interval [$300, $400]. Consider a rule that

provides for damages of $500 in response to Seller’s breach. Buyer’s offer to

rescind the contract for a payment of $400 would provide Seller with no new

information - Seller already knows that Buyer’s valuation is no greater than

$400. Now consider a rule providing for damages of $350. Buyer might now

conceivably offer to cancel the contract in return for a payment from Seller (if

Buyer’s valuation is less than $350), or it might offer Seller a payment to

forego breach (if Buyer’s valuation is more than $350). Thus the type of offer

that Buyer makes conveys information about its valuation and ameliorates the

bargaining costs resulting from asymmetric information. Johnston (1995) offers

an analogous argument to show that bargaining costs can be lower under a

‘standard’, in which an entitlement is dependent on a discretionary judicial

determination, than under a ‘rule’, in which the entitlement is more precisely

defined.

 

Kaplow and Shavell (1995) criticize Ayres and Talley’s analysis on the

grounds that it is not a marginal analysis. They argue that in most contexts in

which bargaining is impossible or prohibitively costly, liability rules will

dominate property rules for the reasons outlined in our discussion of

expectation damages above. Thus for liability rules to dominate property rules

where bargaining is possible does not prove that they generate lower bargaining

costs; the latter point would be proved conclusively only if liability rules

dominate property rules to an even greater extent where bargaining is possible

than where it is impossible.

 

It is perhaps unfortunate that the game-theoretic analysis of bargaining

costs has been used principally to analyze the relative efficiency of liability and

property rules. The more general question is the design of remedies that will

create optimal incentives for the parties to reveal their actual valuations or

other private information about the state of the world. A liability rule (that is,

a rule under which the damage award may be greater or less than the

promisee’s valuation) might create superior incentives compared to a property

rule (that is, one under which the damage award is at or beyond the endpoint

of the promisee’s valuation), but we should be able to make similar

comparisons between different liability rules. The discussion to date has

covered liability and property rules generally, whether located within the law

of property, torts and contract. There is accordingly room for a more focused

look at bargaining costs in contractual settings, with an additional emphasis on

ex ante mechanisms other than judicially-crafted damage rules that might help

to reduce ex post bargaining costs.

 


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