Lecture 11. Formation defenses and performance excuses

Lecture outline

• General principles for enforcing contracts• Regulating contracts• Formation defenses (irrationality, dire

constraints)• Performance excuses (impossibility, frustration

of purpose, mistakes) • Information• Monopoly

General principles

• Bargain theory: law should enforce promises given in a bargain that contains an offer, an acceptance, and a consideration

• Economic principle: generally, those contracts should be enforced that the parties themselves wanted to be enforced (e.g., a promise that resulted in reasonable reliance on it)

Regulating contracts• The issue of enforceability of contracts is part of the more

general issue of when contracts should be regulated by the courts (as opposed to gap-filling that we studied before)

• Generally, rational parties should be allowed to enter into voluntary contracts as long as these contracts do not produce significant negative externalities and as long as enforceability of these contracts does not result in significant transaction costs

• Conditions: • rational parties • voluntary nature • no significant negative externalities, and • no significant transaction costs of enforcement

Reasons for regulating contracts Assumption If violated, contract doctrine

A. Individual rationality

1. Stable, well-ordered preferences 1. Incompetence, incapacity

2. Voluntary nature 2. Duress, necessity, impossibility

B. Transaction costs

1. No spillovers (externalities) 1. Derogating public policy or statutory duty

2. Appropriate information 2. Fraud, failure to disclose, frustration of purpose, mutual mistake

3. Monopoly (voluntary nature?) 3. Necessity, unconscionability or lesion

Formation defenses and performance excuses

• Contracts can be regulated due to:– Formation defenses, whereby the defendant

claims that the conditions for creating a valid contract were not satisfied and, therefore, no valid contract exists

or– Performance excuses, whereby the defendant

admits that a contract exists, but then claims that he/she should be excused from performance because of changed circumstances

Incompetence

• The above reasons for regulating contracts can be viewed as reasons for regulating markets and repairing “market failures”

• If at least one party to a contract is not rational, the contract would not necessarily be socially efficient (examples? What if one party is drunk?)

• Usually, the contract is enforceable to the extent it benefits the incompetent party

• Formation defense or performance excuse?

Duress

• When a party signs a contract under duress it is worse off ex ante than it would have been without the offer of the contract (e.g., “give me your money or your life”)

• Pros and cons of not enforcing contracts under duress:– Pros: reduces incentives to spend resources to put

others under duress and to protect oneself from duress

– Cons: the party under duress might want the contract to be enforceable, given the alternative (if the mugger kills me unless I give him my money, I might prefer him to accept a check)

Proper demands

• Bargaining is supposed to create surplus• Both parties expect to benefit from a bargain,

although typically one party needs to give something to another party to induce cooperation; both parties ex ante want the contract to be enforceable

Improper threats

• Enforcement leads to redistribution rather than creation of wealth

• One party wants enforceability, the other does not (typically)

• Exchange under duress often transfers property to the party that values it less

• Failed bargains do not create surplus while failed coercion may lead to destruction of value

Rule for duress

• A promise extracted as the price to cooperate in creating value is enforceable while a promise extracted by a threat to destroy is unenforceable

Holdup problem

• Renegotiation; changed circumstances• Special case of duress: holdup problem• Alaska Packers Assn v. Domenico• To determine whether there was genuine

duress, the court needs to look at the details of the case (Goebel v. Linn)

Necessity

• A ship is sinking; a captain of another ship offers to rescue people from the sinking ship but asks for a large sum of money. The drowning people agree. Should this contract be enforced?

• Generally, the rescuer is eligible for a reward in excess of the resources employed directly in the process of rescue, but extravagant rewards are not enforceable

• Handout:http://mypage.iu.edu/~malexeev/e351_hand_necessity.pdf

Impossibility

• The doctrines cited above were formation defenses (no valid contract existed to start with)

• Under impossibility doctrine, the dire constraint arises after the contract has been signed (see Goebel v .Linn); formation defense or performance excuse?

• The issue is the ex post allocation of a loss that was not allocated by the parties to the contract ex ante; the way to deal with it depends on the circumstances of the case

Impossibility (cont.)

• From economic efficiency point of view, if a contingency makes performance impossible, liability should be assigned to the party who could reduce risk by taking precautions or spread the risk at least cost

Other doctrines for voiding a contract

• Frustration of purpose (compare to impossibility)

• Mutual mistake about facts (Sherwood v. Walker)

• Mutual mistake about identity (Raffles v. Wichelhaus)

• In the latter case, did the defendant claim “formation defense” or “performance excuse”?

Information

• Special features of information necessitating special treatment in contract law:– Information is costly to discover but cheap to transmit (

special incentives are needed to encourage discovery)– Information is non-rivalrous

• General “economic” principle: contract law should encourage (or at least should not discourage) discovery and transmission of productive “wealth-creating” information and should discourage expenditure of resources on obtaining information aimed purely at redistribution of wealth

Fraud

• Person A wants to sell a car that has serious rust damage to person B. To hide the rust, Apaints over it. B buys the car and soon the paint falls off and B realizes that the car is rusted through. B can sue A to get his money back.

• What is an economic explanation for this rule? That is, what is the efficiency explanation for not enforcing fraudulent contracts?

Duty to disclose

• Person A wants to sell a house to B. A knows that the house is infested with termites but does not disclose this to B. B buys the house and finds out that it has termites. Should B be able to sue A for damages (or even cancel the contract)? (Obde v. Schlemeyer)

• Under common law there is no duty to disclose. The rule is caveat emptor or “let the buyer beware.” (There is, however, a duty not to lie.)

Duty to disclose (cont.)• The law in many US states requires disclosure of the

termites problem and of other serious safety-related problems

• What would be an economic explanation for this rule?• By hiding information about the termites from B, A gives

termites the opportunity to cause more damage. Also, unless there is a duty to disclose safety information, buyers would invest resources in trying to discover information that is readily available to the seller.

• What if the seller didn’t know that the house had termites?

Uniting knowledge and control• Generally, a useful principle for deciding what would

be efficient with respect to disclosure of information in contract negotiations is the following: efficiency requires uniting knowledge and control

• In the rusted car example, the sale of the car to Bseparates A’s knowledge about rust from control of the car; similarly, in the case of termites

• Similarly, the law requires disclosure of safety information about the potential side effects of drugs, danger of smoking, faulty breaks in a car, etc.

Uniting knowledge and control (cont.)

• There is, however, no general duty to disclose• Example: A learns that B has a valuable painting . A knows

this because he studied art history. B does not know the true value of the painting. A buys the painting from B for a low price and then reveals the true value of the painting.

• Does economic efficiency require B to be able to revoke the contract?

• No, because the disclosure requirement would have reduced the incentives for A to acquire useful productive knowledge of art history

• A’s purchase of the painting from B united knowledge about the value of the painting and control over it

Another general principle

• Efficiency is promoted if contracts based on one party’s knowledge of productive information are enforced

• These contracts increase social wealth, although they may also have a redistributive element to them (the buyer of the painting might have benefited more than the social gain from better maintenance of the painting)

• The above argument implies that unilateral mistake does not serve as a valid reason for regulating a contract

• However, efficiency requires that contracts based on one party’s knowledge of purely redistributive information should not be enforced

• In many cases, information has both productive and redistributive aspects

Laidlaw v. Organ

Organ was a merchant in New Orleans who learned about the Treaty of Ghent (which ended the 1812 war between the US and Great Britain) before the news became public. The treaty meant that the British would lift their naval blockade of New Orleans. This would expand the markets for American tobacco, raising its price. So, Organ quickly ordered a large quantity of tobacco from Laidlaw firm at the low war-time price. When the news became public, the price of tobacco went up almost 50%. Laidlaw tried to back out of the contract and sued Organ for not disclosing information about the treaty.

Laidlaw v. Organ (cont.)• Does economic efficiency require disclosure in this case?• Presumably, Organ’s information was purely redistributive

(and he came by it fortuitously)• However, enforcing such contracts provides incentives to be

alert to relevant news and to act on them quickly. This facilitates the workings of markets

• Also, the possibility that contracts can be voided introduces uncertainty, which reduces market activity

• My view: most bargains based on mixed information (productive and redistributive) should be enforced

• Related modern issue: high-frequency trading

Other potential reasons for invalidating contracts

• Contracts to commit crime or contracts that derogate public policy; – No enforcement

• The most obvious reason here is externalities; e.g., the victim of a crime does not participate in contract negotiation, the victims of pollution generated by a contract to produce electric power from coal might be difficult to bring into negotiations (i.e., it’s a high transaction cost argument

Monopoly• Monopoly leads to inefficiencies but only

when combined with asymmetric information• Example: Seller has a widget at zero cost. The seller doesn’t

know buyer’s precise valuation of the widget, but knows that buyer’s valuation has uniform distribution on (0,1). The seller offers to sell the widget at p. The buyer will buy the widget with probability (1-p). The seller’s profit is p(1-p). It is maximized when p=1/2. The seller gets ¼, the buyer gets 1/8 for a total payoff of 3/8. (Do you see why?)

• Note that if the price is restricted to be non-positive, the seller would set p=0 and total welfare would be maximized at ½ (buyer’s benefit), although the seller would be worse off

Monopoly: cartels

• Contracts to sustain a cartel are illegal• Even implicit agreements to act as a cartel are illegal• Under these circumstances, cartels are difficult to

enforce, because the main beneficiary of a cartel are firms outside of a cartel

• Example: 3 identical firms, MC=0, P=a-bQ; show that if firms 1 and 2 adhere to cartel agreement and firm 3 does not, firms 1 and 2 earn less than in 3-firm cartel and firm 3 earns more

Monopoly: exclusive dealing• Monopoly can arise through a long-term exclusive

dealing contract (retailers agree to buy only from the incumbent supplier or have to pay liquidated damages) that effectively prevents entry of potentially more efficient sellers

• Here the externality has to do with potential entrant who is not known at the time of the contract

• Note: buyers might be reluctant to sign, expecting lower prices from potential entrant, but part of that surplus (r) is appropriated by the entrant, thus providing an opportunity for supplier-retailers inefficient contract (similarly to non-price discrimination monopolist, liquidated damages are too high).

Monopoly: exclusive dealing (cont.)

• Earlier, only some of the more efficient entrants are prevented from entry (those who generate less surplus than liquidated damages)

• But incumbent (S) can prevent any entrant (E) at low cost: N buyers with current surplus normalized to 0. Suppose entrant needs at least K buyers, 1<K<N. If S can sign up N*=N-K+1 buyers, no entry occurs. One Nash eq-m (simultaneous game): S offers any b>0 incentive to all buyers and all sign up for exclusive dealing, because if entry is blocked they get 0.

Monopoly: exclusive dealing (cont.)• There is, however, another Nash eq-m were no buyer

signs up if b < buyers’ surplus from entry (r). This equil-m exists if rN* is > than S’s loss from entry

• But a clever contract can result in unique Nash equilibrium where all buyers sign up at low cost to S: If buyer i signs and

1. If fewer than N* buyers (incl. i) sign, i gets b>0 but is released from exclusive dealing contract

2. If N* buyers sign up (incl. i) then i gets r+b and must buy only from S

3. If more than N* sign up then i gets b and must buy from S.

Monopoly: bilateral contracts

• Exclusive dealing is an example of a broader phenomenon of a single agent proposing bilateral contracts to N other agents

• Other examples: resale price maintenance, takeover battle (raider and incumbent shareholders), debt workouts (firm offering debt-equity swaps to creditors), and network externalities (seller selling network good to other agents)

Monopoly: contracts of adhesion

• Monopoly (contracts of adhesion – standard form contracts)– Usually, but not always, enforced– Possible reasons for voiding all or part of contract

include unfair surprise, lack of notice, unequal bargaining power, and substantive unfairness (doctrine of reasonable expectations)

Monopoly: contracts of adhesion (cont.)

• Standard forms do not usually serve as evidence of monopoly or even market power, although they can help sustain a cartel

• Standard forms often enhance efficiency saving on transaction costs of negotiations, may actually promote competition, and provide some assurance that the contract is reasonable

Unconscionable contracts

• Unconscionable contracts (lesion)– Judge decides, not the jury– Often used for marginal cases as a catch-all– Enforcement depends on circumstances– Ex post “unconscionable” contracts can be ex ante

quite reasonable– Individual cases vs. “statistics”– Example: add-on clauses (Williams v. Walker

Thomas Furniture)