Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2011 Lecture 13

Logistics • HW3 is online, due next Thursday (Nov 3) • Second midterm is Wednesday Nov 9 • Cumulative – covers everything up to end of contract law • More weight on more recent material (contracts)

Last Wednesday… • Regulations/immutable rules • Derogation of public policy • Formation defenses and performance excuses • Incompetence (but not drunkenness) • Duress and necessity • Impossibility, and determining the efficient bearer of a risk • Today: more ways to get out of a contract, and remedies for breach

Derogation of public policy

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

Contracts based onbad information

Contracts based on faulty information • Four doctrines for invalidating a contract • Fraud • Failure to disclose • Frustration of purpose • Mutual mistake

Fraud • Fraud: one party was deliberately tricked source: http://www.wyff4.com/r/29030818/detail.html

What if you trick someone by withholding information? • Under the civil law, there is a duty to disclose • If you fail to supply information you should have, contract will be voided – failure to disclose • Less so under the common law • Seller only has to share information about hidden dangers… • …not information that makes a product less valuable but not dangerous • Exception: new products come with “implied warranty of fitness” • Another exception: Obde v Schlemeyer

Duty to disclose under common law • Under common law, seller required to inform buyer about hidden safety risks, generally not other information • But… • Obde v Schlemeyer (1960) • Seller knew building was infested with termites, did not tell buyer • Termites should have been exterminated immediately to prevent further damage • Court in Obde imposed duty to disclose

Duty to disclose under common law • Under common law, seller required to inform buyer about hidden safety risks, generally not other information • But… • Obde v Schlemeyer (1960) • Seller knew building was infested with termites, did not tell buyer • Termites should have been exterminated immediately to prevent further damage • Court in Obde imposed duty to disclose • Some states require used car dealers to reveal major repairs done, sellers of homes to reveal certain types of defects…

What if both parties were misinformed? Frustration of Purpose • Change in circumstance made the original promise pointless • Coronation Cases • “When a contingency makes performance pointless, assign liability to party who can bear risk at least cost”

What if both parties were misinformed? Frustration of Purpose • Change in circumstance made the original promise pointless • Coronation Cases • “When a contingency makes performance pointless, assign liability to party who can bear risk at least cost” Mutual Mistake • Mutual mistake about facts • Circumstances had already changed, but we didn’t know • Logger buys land with timber on it, but forest fire had wiped out the timber the week before • Mutual mistake about identity • Disagreement over what was being sold

Another principle for allocating risks efficiently: uniting knowledge and control • Hadley v Baxendale (miller and shipper) • Hadley knew shipment was time-critical • But Baxendale was deciding how to ship crankshaft (boat or train) • A general principle about information: efficiency generally requires uniting knowledge and control • Contracts that unite knowledge and control are generally efficient, should be upheld • Contracts that separate knowledge and control may be inefficient, should more often be set aside

Mutual vs. Unilateral Mistake • Mutual mistake: neither party had correct information • Contract neither united nor separated knowledge and control • Unilateral mistake: one party has mistaken information • I know your car is a valuable antique, you think it’s worthless • You sell it to me at a low price • Contracts based on unilateral mistake are generally upheld

Unilateral mistake • Mutual mistake: neither party had correct information • Contract neither united nor separated knowledge and control • Unilateral mistake: one party has mistaken information • I know your car is a valuable antique, you think it’s worthless • You sell it to me at a low price • Contracts based on unilateral mistake are generally upheld • Contracts based on unilateral mistake generally unite knowledge and control • And, enforcing them creates an incentive to gather information

Unilateral mistake: Laidlaw v Organ (U.S. Supreme Court, 1815) • War of 1812: British blockaded port of New Orleans • Price of tobacco fell, since it couldn’t be exported • Organ (tobacco buyer) learned the war was over • Immediately negotiated with Laidlaw firm to buy a bunch of tobacco at the depressed wartime price • Next day, news broke the war had ended, price of tobacco went up, Laidlaw sued • Supreme Court ruled that Organ was not required to communicate his information

Unilateral mistake: productive versus redistributive information • Productive information: information that can be used to produce more wealth • Redistributive information: information that can be used to redistribute wealth in favor of informed party • Cooter and Ulen • Contracts based on one party’s knowledge of productive information should be enforced… • …especially if that knowledge was the result of active investment • Contracts based on one party’s knowledge of purely redistributive information, or fortuitously acquired information, should not be enforced

Other reasons a contract may not be enforced

Vague contract terms • Courts will generally not enforce contract terms that are overly vague • Can be thought of as a penalty default • But some exceptions • Parties may commit to renegotiating the contract “in good faith” under certain contingencies

“Shrink-wrap” licenses • Back when software came on disks or CDs… • Box was wrapped in cellophane • Inside, “By unwrapping this box, you agree to the following terms…” • If party given no opportunity to review contract, not binding “Due to the unscheduled trip to the autowrecking yard the school bus will be out of commission for two weeks. Note by reading this letter out loud you have waived any responsibility on our part in perpetuity throughout the known universe.”

What if a party chose not to review the contract? Source: http://www.foxnews.com/scitech/2010/04/15/online-shoppers-unknowingly-sold-souls/

What if a party chose not to review the contract? • British computer game retailer GameStation, on April Fool’s Day, added this to Terms & Conditions customers agreed to before buying online: “By placing an order via this website… you agree to grant us anon-transferable option to claim, for now and for ever more, your immortal soul. Should we wish to exercise this option, you agree to surrender your immortal soul, and any claim you may have on it, within 5 (five) working days of receiving written notification from gamestation.co.uk or one of its duly authorised minions. …If you a) do not believe you have an immortal soul, b) have already given it to another party, or c) do not wish to grant us such a license, please click the link below to nullify this sub-clause and proceed with your transaction.”

Contracts of adhesion • Adhesion: standardized “take-it-or-leave-it” contracts where terms are not negotiable • “Bogus duress” • Not illegal per se, but might attract “closer scrutiny” • A few state courts have adopted a rule: if I put a clause in a contract that I think you would not agree to if you noticed it, then it doesn’t count

What if you signed a contract that was dramatically unfair? • Under the bargain theory, courts should ask only whether a bargain occurred, not whether it was fair • Hamer v Sidway (drinking and smoking) • But both common and civil law have doctrines for not enforcing overly one-sided contracts • Unconscionability/Lesion • “Absence of meaningful choice on the part of one party due to one-sided contract provisions, together with terms which are so oppressive that no reasonable person would make them and no fair and honest person would accept them” • When “the sum total of its provisions drives too hard a bargain for a court of conscience to assist” • Terms which would “shock the conscience of the court”

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965) • “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.”

Unconscionability: Williams v Walker-Thomas Furniture (CA Dist Ct, 1965) • “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party. …In many cases the meaningfulness of the choice is negated by a gross inequality of bargaining power.” • Not normal monopoly cases but “situational monopolies” • Think of Ploof v Putnam (sailboat in a storm), not Microsoft

Remedies for breachof contract

Three broad types of remedy for breach of contract • Party-designed remedies • Remedies specified in the contract • Court-imposed damages • Court may decide promisee entitled to some level of damages • Specific performance • Forces breaching party to live up to contract

Expectation damages • Compensate promisee for the amount he expected to benefit from performance • You agreed to buy an airplane for $350,000 • You expected $500,000 of benefit from it • Expectation damages: if I breach, I owe you that benefit • ($500,000 if you already paid, $150,000 if you didn’t) • “Positive damages” • Make promisee indifferent between performance and breach

Reliance damages • Reimburse promisee for cost of any reliance investments made, but not for additional surplus he expected to gain • Restore promisee to level of well-being before he signed the contract • You contracted to buy the plane and built a hangar • If I breach, I owe you what you spent on the hangar, nothing else • “Negative damages” – undo the negative (harm) that occurred

Opportunity cost damages • Give promisee benefit he would have gotten from his next-best option • Make promisee indifferent between breach of the contract that was signed, and performance of best alternative contract • You value plane at $500,000 • You contract to buy plane from me for $350,000 • Someone else was selling similar plane for $400,000 • By the time I breach, that plane is no longer available • I owe you $100,000 – the benefit you would have gotten from buying the other seller’s plane

Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Purdue football game for $50 • Expectation damages: you owe me value of game minus $50 • If I pay scalper $150, then expectation damages = $100 • Reliance damages: maybe 0, or cost of whatever pre-game investments I made

Example: expectation, reliance, and opportunity cost damages • You agree to sell me ticket to Wisconsin-Purdue football game for $50 • Expectation damages: you owe me value of game minus $50 • If I pay scalper $150, then expectation damages = $100 • Reliance damages: maybe 0, or cost of whatever pre-game investments I made • When you agreed to sell me ticket, othertickets available for $70 • Opportunity cost damages: $80 • (I paid a scalper $150 to get in; I would have been $80 better off if I’d ignored your offer and paid someone else $70)

Ranking damages ContractI Sign BestAlternative Do Nothing ³ ³ = = = Breach +ExpectationDamages Breach +Opportunity Cost Damages Breach +RelianceDamages ³ ³ ExpectationDamages Opportunity CostDamages RelianceDamages ³ ³ $100 $80 $15

Hawkins v McGee (“hairy hand case”) • Hawkins had a scar on his hand • McGee promised surgery to “make the hand a hundred percent perfect” • Surgery was a disaster, left scar bigger and covered with hair

Hawkins v McGee (“hairy hand case”) $ + Expectation Damages + Opp Cost Damages Expectation Damages Reliance Damages Opp Cost Damages + Reliance Damages Initial Wealth Hand Hairy Scarred Nextbestdoctor 100%Perfect

Other court-ordered remedies • Restitution • Return money that was already received • Disgorgement • Give up wrongfully-gained profits

Other court-ordered remedies • Restitution • Return money that was already received • Disgorgement • Give up wrongfully-gained profits • Specific Performance • Promisor is forced to honor promise • Civil law: often ordered instead of money damages • Common law: money damages more common; S.P. sometimes used when seller breaches contract to sell a unique good • Like injunctive relief

Expectation damages vs. specific performance • Peevyhouse v Garland Coal and Mining Co(OK Supreme Court, 1962) • Garland contracted to strip-minecoal on Peevyhouse’s farm • Contract specified Garlandwould restore property to originalcondition; Garland did not • Restoration would cost $29,000 • But “diminution in value” of farmwas only $300 • Original jury awarded $5,000 indamages, both parties appealed • OK Supreme Court reduceddamages to $300

Expectation damages vs. specific performance • At first, sounds like a perfect example of efficient breach • Performing last part of contract would cost $29,000 • Benefit to Peevyhouses would be $300 • Efficient to breach and pay expectation damages, which is what happened • But… • Most coal mining contracts: standard per-acre diminution payment • Peevyhouses refused to sign contract unless it specifically promised the restorative work • Dissent: Peevyhouses entitled to specific performance • (Peevyhouses seemed to value condition of property much more highly than change in market value)

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

Party-designed remedies • Remedy for breach could be written directly into contract • But common law courts don’t always enforce remedy terms • Liquidated damages– party-specified damages that reasonably approximate actual harm done by breach • Penalty damages – damages greater than actual harm done • Civil law courts are generally willing to enforce penalty damages • But common law courts often do not

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Penalty Damages • Peevyhouse v Garland Coal • Peevyhouses only wanted farm strip-mined if it would be restored to original condition after • Suppose coal extracted worth $70,000 • Garland paid $25,000 for rights to mine it • Restoration work would cost $30,000 • Diminution of value was $300 • So liquidated damages would be $300 • Suppose Peevyhouses got $40,000 of disutility from land being left in poor condition

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Liquidated damages Peevyhouses Sign Don’t Garland Coal (0, 0) Restore property Don’t, pay damages (25,000, 15,000) (-14,700, 44,700) • If damages limited to liquidated damages… • Peevyhouses shouldn’t believe restorative work will get done • So Peevyhouses better off refusing to sign • Even though mining and restoring Pareto-dominates

Coal worth $70,000Garland to pay $25,000Restoration would cost $30,000Liquidated damages are $300Peevyhouses value restoration at $40,000 Penalty damages Peevyhouses Sign Don’t Garland Coal (0, 0) Restore property Don’t, pay penalty (25,000, 15,000) (25,000, 5,000) • If penalty clauses in contracts enforceable… • Write contract with $40,000 penalty for leaving land unrestored • Now restoration work would get done, so Peevyhouses willing to sign • But if courts won’t enforce penalty damages, this won’t work

Penalty clauses • Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus • I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late • Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time • Either way, you get $150,000 if house is late, $200,000 if on time • Courts generally enforce bonus clauses, so no problem!

Penalty clauses • Whatever you can accomplish with penalty clause, you could also accomplish with performance bonus • I agree to pay $200,000 to get house built, but I want you to pay a $50,000 penalty if it’s late • Alternatively: I agree to pay $150,000 for house, plus a $50,000 performance bonus if it’s completed on time • Either way, you get $150,000 if house is late, $200,000 if on time • Courts generally enforce bonus clauses, so no problem! • Similarly, Peevyhouse example • Peevyhouses get $25,000 for mining rights, $40,000 penalty if land is not restored • Equivalently, get $65,000 for mining rights, pay $40,000 bonus if restoration is completed • But, if intent of contract is too transparent, still might not be enforced

Econ 522 Economics of Law