Download WEB NOTES - Pearson Higher Education

WEB NOTES
Sixth Edition
The following are the web notes for the sixth edition of Law and Economics by Robert D.
Cooter and Thomas S. Ulen. Our intent in these notes is to extend the material in the text by
describing some additional issues, articles, cases, and books. Because the fields of law,
economics, and law and economics are not standing still – because, that is, scholars are adding
interesting new material all the time, we may supplement, alter, and add to these notes from time
to time.
Each note begins with a copy of the material from the text about the content of the web note
and the page on which that web note can be found. We will from time to time insert new
material, update some of the entries, and add some additional material. You should be able to
download pdf versions of each chapter’s web notes and of the entire set of web notes for all 13
chapters.
We have found that the very best students and their instructors from all over the world pay
close attention to these web notes. They often have good ideas about how to add to the entries
already here and suggestions about articles, cases, books, and topics that would be instructive to
add. We would be grateful for any comments or suggestions about any of the notes.
Chapter 9
Web Note 9.1 (p. 320)
For more on cases illustrating the difficulties of computing damages and further
discussion, see our website.
In the text, we have sought to give you a comprehensive, economically minded account of
how to compute damages for breach of contract. There are some additional issues that would be
covered in a full-semester class in contract law. Rather than take this opportunity to look at all
those issues, we instead will give you edited versions of some famous cases to illustrate some
aspects of applying the concepts of Chapter 9. And as a bonus, we include a relatively recent
U.S. Supreme Court case that might be said to illustrate some of the perplexing issues of
unconscionability.
This case illustrates a very important issue that will arise in the next several cases, too.
When someone breaches a contract, should they be held liable for the cost of completing the
contract or for the diminution in the value of the uncompleted performance? Here, as you will
see, a contractor’s plumbing subcontractor did not use the interior pipe specified in the contract.
He used an alternative pipe that was, apparently, identical to one that he should have used.
Admitting that he breached the contract, should the contractor be held liable for the very large
Web Notes – Sixth Edition
Cooter & Ulen
costs of tearing out the walls and replacing the incorrect pipe with the correct pipe or for the
(perhaps trivial) diminution in the value of the house containing the noncomplying pipe?
JACOB & YOUNGS, Inc., v. KENT
230 N.Y. 239, 129 N.E. 889 (1921)
Court of Appeals of New York.
Action by Jacob & Youngs, Incorporated, against George E. Kent. From an order of the
Appellate Division ( 187 App. Div. 100, 175 N. Y. Supp. 281), reversing judgment for defendant
entered on verdict directed by the court and granting new trial, defendant appeals.Order affirmed
and judgment absolute directed in favor of plaintiff.McLaughlin, Pound, and Andrews, JJ.,
dissenting.
Cardozo, J.
The plaintiff built a country residence for the defendant at a cost of upwards of $77,000, and
now sues to recover a balance of $3,483.46, remaining unpaid. The work of construction ceased
in June, 1914, and the defendant then began to occupy the dwelling. There was no complaint of
defective performance until March, 1915. One of the specifications for the plumbing work
provides that “All wrought-iron pipe must be well galvanized, lap welded pipe of the grade
known as‘standard pipe’ of Reading manufacture.”
The defendant learned in March, 1915, that some of the pipe, instead of being made in
Reading, was the product of other factories. The plaintiff was accordingly directed by the
architect to do the work anew. The plumbing was then encased within the walls except in a few
places where it had to be exposed. Obedience to the order meant more than the substitution of
other pipe. It meant the demolition at great expense of substantial parts of *241 the completed
structure.
The plaintiff left the work untouched, and asked for a certificate that the final payment was
due. Refusal of the certificate was followed by this suit.
The evidence sustains a finding that the omission of the prescribed brand of pipe was neither
fraudulent nor willful. It was the result of the oversight and inattention of the plaintiff’s
subcontractor.
Reading pipe is distinguished from Cohoes pipe and other brands only by the name of the
manufacturer stamped upon it at intervals of between six and seven feet. Even the defendant’s
architect, though he inspected the pipe upon arrival, failed to notice the discrepancy.
The plaintiff tried to show that the brands installed, though made by other manufacturers,
were the same in quality, in appearance, in market value, and in cost as the brand stated in the
contract-that they were, indeed, the same thing, though manufactured in another place. The
evidence was excluded, and a verdict directed for the defendant. The Appellate Division
reversed,and granted a new trial.
We think the evidence, if admitted, would have supplied some basis for the inference that the
defect was insignificant in its relation to the project. The courts never say that one who makes a
contract fills the measure of his duty by less than full performance. They do say, however, that
an omission, both trivial and innocent, will sometimes be atoned for by allowance of the
resulting damage, and will not always be the breach of a condition to be followed by a forfeiture.
[Citations omitted.] …
2
Web Notes – Sixth Edition
Cooter & Ulen
Considerations partly of justice and partly of presumable intention are to tell us whether this
or that promise shall be placed in one class or in another. The simple and the uniform will call
for different remedies from the multifarious and the intricate. The margin of departure within the
range of normal expectation upon a sale of common chattels will vary from the margin to be
expected upon a contract for the construction of a mansion or a ‘skyscraper.’
There will be harshness sometimes and oppression in the implication of a condition when the
thing upon which labor has been expended is incapable of surrender because united to the land,
and equity and reason in **891 the implication of a like condition when the subject-matter, if
defective, is in shape to be returned. From the conclusion that promises may not be treated as
dependent to the extent of their uttermost minutiae without a sacrifice of justice, the progress is a
short one to the conclusion that they may not be so treated without a perversion of intention.
Intention not otherwise revealed may be presumed to hold in contemplation the reasonable and
probable. If something else is in view, it must not be left to implication. There will be no
assumption of a purpose to visit venial faults with oppressive retribution.Those who think more
of symmetry and logic in the development of legal rules than of practical adaptation to the
attainment of a just result will be troubled by a classification*243 where the lines of division are
so wavering and blurred. Something, doubtless, may be said on the score of consistency and
certainty in favor of a stricter standard. The courts have balanced such considerations against
those of equity and fairness, and found the latter to be the weightier.
The decisions in this state commit us to the liberal view, which is making its way, nowadays,
in jurisdictions slow to welcome it. … Where the line is to be drawn between the important and
the trivial cannot be settled by a formula.‘In the nature of the case precise boundaries are
impossible.’ 2 Williston on Contracts, §841. The same omission may take on one aspect or
another according to its setting. Substitutionof equivalents may not have the same significance in
fields of art on the one side and inthose of mere utility on the other. Nowhere will change be
tolerated, however, if it is so dominantor pervasive as in any real or substantial measure to
frustrate the purpose of the contract. …
The question is one of degree, to be answered, if there is doubt, by the triers of the facts …
and, if the inferences are certain, by thejudges of the law []. We must weigh the purpose to be
served, the desire to be gratified, the excuse for deviation from the letter, the cruelty of enforced
adherence. Then only can we tell whether literal fulfillment is to be implied by law as a
condition. This is not to say that the parties are not free by apt and certain words to effectuate a
purpose that performance of every term shall be a condition of recovery. That question is not
here. This is merely to say that the law will be slow to impute the purpose, in the silence of the
parties, where the significance *244 of the default is grievously outof proportion to the
oppression of the forfeiture. The willful transgressor must accept the penaltyof his transgression.
[] For him there is nooccasion to mitigate the rigor of implied conditions. The transgressor whose
default is unintentionaland trivial may hope for mercy if he will offer atonement for his wrong. []
In the circumstances of this case, we think the measure of the allowance is not the cost of
replacement, which would be great, but the difference in value, which would be either nominal
or nothing. Some of the exposed sections might perhaps have been replaced at moderate expense.
The defendant did not limit his demand to them, but treated the plumbing as a unit to be
corrected from cellar to roof. In point of fact, the plaintiff never reached the stage at which
evidence of the extent of the allowance became necessary. The trial court had excluded evidence
that the defect was unsubstantial, and in view of that ruling there was no occasion for the
plaintiff to go farther with an offer of proof. We think, however, that the offer, if it had been
3
Web Notes – Sixth Edition
Cooter & Ulen
made, would not of necessity have been defective because directed to difference in value. It is
true that in most cases the cost of replacement is the measure. []Theowner is entitled to the
money which will permit him to complete, unless the cost of completionis grossly and unfairly
out of proportion to the good to be attained. When that is true, themeasure is the difference in
value. Specifications call, let us say, for a foundation built ofgranite quarried in Vermont. On the
completion of the building, the owner learns that throughthe blunder of a subcontractor part of
the foundation has been built of granite of the samequality quarried in New Hampshire. The
measure of allowance is not the cost of reconstruction.
‘There may be *245 omissions of that which could not afterwards be supplied exactly as
called for by the contract without taking down the building to its foundations, and at the same
time the omission may not affect the value of the building for use or otherwise, except so slightly
as to be hardly appreciable.’ The rule that gives a remedy in cases of substantial performance
with compensation for defects of trivial or inappreciable importance has been developed by the
courts as an instrument of justice. The measure of the allowance must be shaped to the same end.
The order should be affirmed, and judgment absolute directed in favor of the plaintiff upon
the stipulation, with costs in all courts.
McLaughlin, J.
I dissent. The plaintiff did not perform its contract. Its failure to do so was either intentional
ordue to gross neglect which, under the uncontradicted facts, amounted to the same thing, nor did
it make any proof of the cost of compliance, where compliance was possible.Under its contract it
obligated itself to use in the plumbing only pipe (between 2,000 and2,500 feet) made by the
Reading Manufacturing Company. The first pipe delivered was about1,000 feet and the
plaintiff's superintendent then called the attention of the foreman of the subcontractor,who was
doing the plumbing, to the fact that the specifications annexed to the contract required all pipe
used in the plumbing to be of the Reading Manufacturing Company.They then examined it for
the purpose of ascertaining whether this delivery was of that manufactureand found it was.
Thereafter, as pipe was required in the progress of the work, theforeman of the subcontractor
would leave word at its *246 shop that he wanted a specifiednumber of feet of pipe, without in
any way indicating of what manufacture. Pipe would thereafterbe delivered and installed in the
building, without any examination whatever. Indeed, noexamination, so far as appears, was made
by the plaintiff, the subcontractor, defendant’s architect, or anyone else, of any of the pipe except
the first delivery, until after the building hadbeen completed. Plaintiff’s architect then refused to
give the certificate of completion, uponwhich the final payment depended, because all of the pipe
used in the plumbing was not of thekind called for by the contract. After such refusal, the
subcontractor removed the covering orinsulation from about 900 feet of pipe which was exposed
in the basement, cellar, and attic,and all but 70 feet was found to have been manufactured, not by
the Reading Company, but byother manufacturers, some by the Cohoes Rolling Mill Company,
some by the National SteelWorks, some by the South Chester Tubing Company, and some which
bore no manufacturer’smark at all. The balance of the pipe had been so installed in the building
that an inspection ofit could not be had without demolishing, in part at least, the building itself.
I am of the opinion the trial court was right in directing a verdict for the defendant. The
plaintiff agreed that all the pipe used should be of the Reading Manufacturing Company. Only
about two-fifths of it, so far as appears, was of that kind. If more were used, then the burden of
proving that fact was upon the plaintiff, which it could easily have done, since it knew where the
pipe was obtained. The question of substantial performance of a contract of the character of the
4
Web Notes – Sixth Edition
Cooter & Ulen
one under consideration depends in no small degree upon the good faith of the contractor. If the
plaintiff had intended to, and had, complied with the terms of the contract except as to minor
omissions, due to inadvertence, then he might be allowed to recover the contract price, less the
amount *247 necessary to fully compensate the defendant for damages caused by such
omissions. [] But that is not this case. It installed between 2,000 and 2,500 feet of pipe, of which
only1,000 feet at most complied with the contract. No explanation was given why pipe called for
by the contract was not used, nor that any effort made to show what it would cost to remove the
pipe of other manufacturers and install that of the Reading Manufacturing Company. The
defendant had a right to contract for what he wanted. He had a right before making payment to
get what the contract called for. It is no answer to this suggestion to say that the pipe put inwas
just as good as that made by the Reading Manufacturing Company, or that the difference in value
between such pipe and the pipe made by the Reading Manufacturing Company would be either
‘nominal or nothing.’ Defendant contracted for pipe made by the Reading
ManufacturingCompany. What his reason was for requiring this kind of pipe is of no importance.
Hewanted that and was entitled to it. It may have been a mere whim on his part, but even so,
hehad a right to this kind of pipe, regardless of whether some other kind, according to the
opinion of the contractor or experts, would have been ‘just as good, better, or done just as well.’
He agreed to pay only upon condition that the pipe installed were made by that company and he
ought not to be compelled to pay unless that condition be performed. []
The rule, therefore, of substantial performance,with damages for unsubstantial omissions, has
no application. [] *248 What was said by this court in [an earlier case] is quite applicable here:
‘I suppose it will be conceded that everyone has a right to build his house, his cottage or his store
after such a model and in such style as shall best accord with his notions of utility or be most
agreeable to his fancy. The specifications of the contract become the law between the parties until
voluntarily changed. If the owner prefers a plain and simple Doric column, and has so provided in
the agreement, the contractor has no right to put in its place the more costly and elegant
Corinthian. If the owner, having regard to strength and durability, has contracted for walls of
specified materials to be laid in a particular manner, or for a given number of joists and beams,
the builder has no right to substitute his own judgment or that of others. Having departed from the
agreement, if performance has not been waived by the other party, the law will not allow him to
allege that he has made as good a building as the one he engaged to erect. He can demand
payment only upon and according to the terms of his contract, and if the conditions on which
payment is due have not been performed, then the right to demand it does not exist. To hold a
different doctrine would be simply to make another contract, and would be giving to parties an
encouragement to violate their engagements, which the just policy of the law does not permit.’ (
17 N. Y. 186, 72 Am. Dec. 422).
I am of the opinion the trial court did not err in ruling on the admission of evidence or in
directing a verdict for the defendant.For the foregoing reasons I think the judgment of the
Appellate Division should be reversedand the judgment of the Trial Term affirmed.
Hiscock, C. J., and Hogan and Crane, JJ., concur with Cardozo, J.
Pound and Andrews, JJ., concur with McLaughlin, J.
Order affirmed, etc.
5
Web Notes – Sixth Edition
Cooter & Ulen
This is a case that asks a similar question to that posed in Jacob & Youngs: what’s the
appropriate remedy for breach when there is a large difference between the cost of complete
performance and the diminution in value of non- or partial compliance? In this instance, note
that there may be a strong argument in favor of the remedy of specific performance. What might
have happened if the court had awarded specific performance to the Peevyhouses?
Willie PEEVYHOUSE and Lucille Peevyhouse
v.
GARLAND COAL & MINING COMPANY
382 P. 2d 109 (Okla. 1962), cert den., 375 U.S. 906 (1963)
Jackson, Justice.
In the trial court, plaintiffs Willie and Lucille Peevyhouse sued the defendant, Garland
Coaland Mining Company, for damages for breach of contract. Judgment was for plaintiffs in
anamount considerably less than was sued for. Plaintiffs appeal and defendant cross-appeals.In
the briefs on appeal, the parties present their argument and contentions under several
propositions;however, they all *111 stem from the basic question of whether the trial court
properlyinstructed the jury on the measure of damages.
Briefly stated, the facts are as follows: plaintiffs owned a farm containing coal deposits,
andin November, 1954, leased the premises to defendant for a period of five years for coal
miningpurposes. A ‘stripmining’ operation was contemplated in which the coal would be taken
frompits on the surface of the ground, instead of from underground mine shafts. In addition to
theusual covenants found in a coal mining lease, defendant specifically agreed to perform
certainrestorative and remedial work at the end of the lease period. It is unnecessary to set out the
detailsof the work to be done, other than to say that it would involve the moving of many
thousandsof cubic yards of dirt, at a cost estimated by expert witnesses at about
$29,000.00.However, plaintiffs sued for only $25,000.00.
During the trial, it was stipulated that all covenants and agreements in the lease contract
hadbeen fully carried out by both parties, except the remedial work mentioned above;
defendantconceded that this work had not been done.
Plaintiffs introduced expert testimony as to the amount and nature of the work to be done,
andits estimated cost. Over plaintiffs’ objections, defendant thereafter introduced expert
testimonyas to the ‘diminution in value’ of plaintiffs’ farm resulting from the failure of defendant
torender performance as agreed in the contract – that is, the difference between the present
valueof the farm, and what its value would have been if defendant had done what it agreed to do.
At the conclusion of the trial, the court instructed the jury that it must return a verdict
forplaintiffs, and left the amount of damages for jury determination. On the measure of
damages,the court instructed the jury that it might consider the cost of performance of the work
defendantagreed to do, ‘together with all of the evidence offered on behalf of either party’.
It thus appears that the jury was at liberty to consider the ‘diminution in value’ of plaintiffs’
farm as well as the cost of ‘repair work’ in determining the amount of damages.It returned a
verdict for plaintiffs for $5000.00 – only a fraction of the ‘cost of performance’,but more than
the total value of the farm even after the remedial work is done. [Emphasis in the original.]
On appeal, the issue is sharply drawn. Plaintiffs contend that the true measure of damages
inthis case is what it will cost plaintiffs to obtain performance of the work that was not done
6
Web Notes – Sixth Edition
Cooter & Ulen
becauseof defendant’s default. Defendant argues that the measure of damages is the cost of
performance ‘limited, however, to the total difference in the market value before and after
thework was performed’.
It appears that this precise question has not heretofore been presented to this court. ...
Plaintiffs rely on Groves v. John Wunder Co., 205 Minn. 163, 286 N.W. 235, 123 A.L.R.
502.In that case, the Minnesota court, in a substantially similar situation, adopted the ‘cost of
performance’ rule as-opposed to the ‘value’ rule. The result was to authorize a jury to
giveplaintiff damages in the amount of $60,000, where the real estate concerned would have
beenworth only $12,160, even if the work contracted for had been done.
*112 It may be observed that Groves v. John Wunder Co., supra, is the only case which
hascome to our attention in which the cost of performance rule has been followed under
circumstanceswhere the cost of performance greatly exceeded the diminution in value resulting
fromthe breach of contract. Incidentally, it appears that this case was decided by a plurality
ratherthan a majority of the members of the court.
Defendant relies principally upon [a number of cases from other jurisdictions]. These were
all cases in which, undersimilar circumstances, the appellate courts followed the ‘value’ rule
instead of the ‘cost ofperformance’ rule. … Nevertheless, it is ofsome significance that three out
of four appellate courts have followed the diminution in valuerule under circumstances where, as
here, the cost of performance greatly exceeds the diminutionin value.
The explanation may be found in the fact that the situations presented are artificial ones. It
ishighly unlikely that the ordinary property owner would agree to pay $29,000 (or its
equivalent)for the construction of ‘improvements’ upon his property that would increase its
valueonly about ($300) three hundred dollars. The result is that we are called upon to apply
principlesof law theoretically based upon reason and reality to a situation which is basically
unreasonableand unrealistic. …
[The Court approvingly cites a Virginia opinion in which that court held that
“Notwithstanding the provisions of this chapter, no person can recover a greateramount in
damages for the breach of an obligation, than he would have gained by the full
performancethereof on both sides …” and “Damages must, in all cases, be reasonable, and where
an obligation of any kindappears to create a right to unconscionable and grossly oppressive
damages, contrary to substantialjustice no more than reasonable damages can be recovered.”
Although it is true that the [principles are] most often [applied] in tort cases,they are by their
own terms, and the decisions of this court, also applicable in actions for damagesfor breach of
contract. It would seem that they are peculiarly applicable here where, underthe ‘cost of
performance’ rule, plaintiffs might recover an amount about nine times thetotal value of their
farm. Such would seem to be ‘unconscionable and grossly oppressive damages,contrary to
substantial justice’ within the meaning of the statute. Also, it can hardly bedenied that if
plaintiffs here are permitted to recover under the ‘cost of performance’ rule,they will receive a
greater benefit from the breach than could be gained from full performance.’ …
…
We therefore hold that where, in a coal mining lease, lessee agrees to perform certain
remedialwork on the premises concerned at the end of the lease period, and thereafter the
contractis fully performed by both parties except that the remedial work is not done, the
measureof damages in an action by lessor against lessee for damages for breach of contract is
ordinarilythe reasonable cost of performance of the work; however, where the contract
provisionbreached was merely incidental to the main purpose in view, and where the economic
7
Web Notes – Sixth Edition
Cooter & Ulen
benefitwhich would result to lessor by full performance of the work is grossly disproportionate to
thecost of performance, the damages which lessor may recover are limited to the diminution
invalue resulting to the premises because of the non-performance. …
The above holding disposes of all of the arguments raised by the parties on appeal.
Under the most liberal view of the evidence herein, the diminution in value resulting to
thepremises because of non-performance of the remedial work was $300.00. After a
carefulsearch of the record, we have found no evidence of a higher figure, and plaintiffs do not
arguein their briefs that a greater diminution in value was sustained. It thus appears that the
judgmentwas clearly excessive, and that the amount for which judgment should have
beenrendered is definitely and satisfactorily shown by the record. …
We are of the opinion that the judgment of the trial court for plaintiffs should be, and it
ishereby, modified and reduced to the sum of $300.00, and as so modified it is affirmed.
Welch, Davison, Halley, and Johnson, JJ., concur.
Williams, C. J., Blackbird, V. C. J., and Irwin and Berry, JJ., dissent.
Irwin, Justice (dissenting).
…
Defendant admits that it failed to perform its obligations that it agreed and contracted to
performunder the lease contract and there is nothing in the record which indicates that defendant
could not perform its obligations. Therefore, in my opinion defendant’s breach of the
contractwas willful and not in good faith.
Although the contract speaks for itself, there were several negotiations between the
plaintiffsand defendant before the contract was executed. Defendant admitted in the trial of the
action,that plaintiffs insisted that the above provisions be included in the contract and that
theywould not agree to the coal mining lease unless the above provisions were included.
In consideration for the lease contract, plaintiffs were to receive a certain amount as
royaltyfor the coal produced and marketed and in addition thereto their land was to be restored
asprovided in the contract.
…
The cost for performing the contract in question could have been reasonably
approximatedwhen the contract was negotiated and executed and there are no conditions now
existingwhich could not have been reasonably anticipated by the parties. Therefore, defendant
hadknowledge, when it prevailed upon the plaintiffs to execute the lease, that the cost of
performancemight be disproportionate to the value or benefits received by plaintiff for the
performance.
Defendant has received its benefits under the contract and now urges, in substance,
thatplaintiffs’ measure of damages for its failure to perform should be the economic value of
performanceto the plaintiffs and not the cost of performance.
If a peculiar set of facts should exist where the above rule should be applied as the
propermeasure of damages, (and in my judgment those facts do not exist in the instant case)
beforesuch rule should be applied, consideration should be given to the benefits received or
contractedfor by the party who asserts the application of the rule.
Defendant did not have the right to mine plaintiffs’ coal or to use plaintiffs’ property for
itsmining operations without the consent of plaintiffs. Defendant had knowledge of the
benefitsthat it would receive under the contract and the approximate cost of performing the
contract.With this knowledge, it must be presumed that defendant thought that it would be to its
8
Web Notes – Sixth Edition
Cooter & Ulen
economicadvantage to enter into the contract with plaintiffs and that it would reap benefits
fromthe contract, or it would have not entered into the contract.
Therefore, if the value of the performance of a contract should be considered in
determiningthe measure of damages for breach of a contract, the value of the benefits received
under thecontract by a party who breaches a contract should also be considered. However, in my
judgment,to give consideration to either in the instant action, completely rescinds and holds
fornaught the solemnity of the contract before us and makes an entirely new contract for
theparties.
…
In the instant action defendant has made no attempt to even substantially perform. The
contract in question is not immoral, is not tainted with fraud, and was not entered into
throughmistake or accident and is not contrary to public policy. It is clear and unambiguous and
theparties understood the terms thereof, and the approximate cost of fulfilling the
obligationscould have been approximately ascertained. There are no conditions existing now
which couldnot have been reasonably anticipated when the contract was negotiated and
executed. The defendantcould have performed the contract if it desired. It has accepted and
reaped the benefitsof its contract and now urges that plaintiffs’ benefits under the contract be
denied. If plaintiffs’ benefits are denied, such benefits would inure to the direct benefit of the
defendant.
Therefore, in my opinion, the plaintiffs were entitled to specific performance of the
contractand since defendant has failed to perform, the proper measure of damages should be the
costof performance. Any other measure of damage would be holding for naught the express
provisionsof the contract; would be taking from the plaintiffs the benefits of the contract and
placingthose benefits in defendant which has failed to perform its obligations; would be
grantingbenefits to defendant without a resulting obligation; and would be completely rescinding
thesolemn obligation of the contract for the benefit of the defendant to the detriment of
theplaintiffs by making an entirely new contract for the parties.
I therefore respectfully dissent to the opinion promulgated by a majority of my associates.
Here is a more recent case about the same issues of diminution-of-value versus completionof-performance as the appropriate measure of damages in a breach case.
AMERICAN STANDARD, INC. v.SCHECTMAN
80 A.D.2d 318, 439 N.Y.S.2d 529 (1981).
Hancock, Justice.
Plaintiffs have recovered a judgment on a jury verdict of $90,000 against defendant for
hisfailure to complete grading and to take down certain foundations and other subsurface
structuresto one foot below the grade line as promised. Whether the court should have charged
thejury, as defendant Schectman requested, that the difference in value of plaintiffs’ propertywith
and without the promised performance was the measure of the damage is the main pointin his
appeal.We hold that the request was **531 properly denied and that the cost ofcompletion – not
the difference in value – was the proper measure. Finding no other basis for reversal,we affirm.
9
Web Notes – Sixth Edition
Cooter & Ulen
Until 1972, plaintiffs operated a pig iron manufacturing plant on land abutting the
NiagaraRiver in Tonawanda. On the 26-acre parcel were, in addition to various industrial and
officebuildings, a 60-ton blast furnace, large lifts, hoists and other equipment for transporting
andstoring ore, railroad tracks, cranes, diesel locomotives and sundry implements and
devicesused in the business. Since the 1870’s plaintiffs’ property, under several different owners,
hadbeen the site of various industrial operations. Having decided to close the plant, plaintiffs
onAugust 3, 1973 made a contract in which they agreed to convey the buildings and *320
otherstructures and most of the equipment to defendant, a demolition and excavating contractor,
inreturn for defendant’s payment of $275,000 and his promise to remove the equipment,
demolishthe structures and grade the property as specified.
We agree with Trial Term’s interpretation of the contract as requiring defendant to removeall
foundations, piers, headwalls, and other structures, including those under the surface andnot
visible and whether or not shown on the map attached to the contract, to a depth of
approximatelyone foot below the specified grade lines.The proof from plaintiffs’ witnessesand
the exhibits, showing a substantial deviation from the required grade lines and the
existenceabove grade of walls, foundations and other structures, support the finding, implicit
inthe jury’s verdict, that defendant failed to perform as agreed. Indeed, the testimony of
defendant’switnesses and the position he has taken during his performance of the contract
andthroughout this litigation (which the trial court properly rejected), viz., that the contract
didnot require him to remove all subsurface foundations, allow no other conclusion.
We turn to defendant’s argument that the court erred in rejecting his proof that
plaintiffssuffered no loss by reason of the breach because it makes no difference in the value of
theproperty whether the old foundations are at grade or one foot below grade and in denying
hisoffer to show that plaintiffs succeeded in selling the property for $183,000 – only $3,000
lessthan its full fair market value. By refusing this testimony and charging the jury that the cost
ofcompletion (estimated at $110,500 by plaintiffs’ expert), not diminution in value of the
property,was the measure of *321 damage the court, defendant contends, has unjustly
permittedplaintiffs to reap a windfall at his expense. Citing the definitive opinion of Chief Judge
Cardozoin Jacob & Youngs, Inc. v. Kent, 230 N.Y. 239, 129 N.E. 889, he maintains that the
factspresent a case “of substantial performance” of the contract with omissions of “trivial or
inappreciableimportance” (p. 245, 129 N.E. 889), and that because the cost of completion was
“grossly and unfairly out of proportion to the good to be attained”, (p. 244, 129 N.E. 889),
theproper measure of damage is diminution in value.
…
Not in all cases of claimed “economic waste” where the cost of completing performance of
thecontract would be large and out of proportion to the resultant benefit to the property have
thecourts adopted diminution in value as the measure of damage. Under the Restatement rule,
thecompletion of the contract must involve “unreasonable economic waste” and the
illustrativeexample given is that of a house built with pipe different in name from but equal in
quality tothe brand stipulated in the contract as in Jacob & Youngs, Inc. v. Kent. In Groves v.
JohnWunder Co., 205 Minn. 163, 286 N.W. 235, plaintiff had leased property and conveyed
agravel plant to defendant in exchange for a sum of money and for defendant’s commitment
toreturn the property to plaintiff at the end of the term at a specified grade-a promise
defendantfailed to perform. Although the cost of the fill to complete the grading was $60,000
and thetotal value of the property, graded as specified in the contract, only $12,160 the court
rejectedthe “diminution in value” rule[.]
10
Web Notes – Sixth Edition
Cooter & Ulen
…
In the case before us, plaintiffs chose to accept as part of the consideration for the
promisedconveyance of their valuable plant and machines to defendant his agreement to grade
theproperty as specified and to remove the foundations, piers and other structures to a depth
ofone foot below grade to prepare the property for sale. It cannot be said that the grading and
theremoval of the structures were incidental to plaintiffs’ purpose of “achieving a reasonably
attractivevacant plot for resale” (compare Peevyhouse v. Garland Coal & Min. Co.). Norcan
defendant maintain that the damages which would naturally flow from his failure to *324do the
grading and removal work and which could reasonably be said to have been in the
contemplationof the parties when the contract was made would not be the reasonable cost of
completion. That the fulfillmentof defendant’s promise would (contrary to plaintiffs’ apparent
expectations) add little or nothing to the sale value of the property does not excuse the default.
As in the hypotheticalcase posed in Chamberlain v. Parker, 45 N.Y. 569, [] of the man who
“chooses to erect a monument to his caprice or folly on his premises,and employs and pays
another to do it”, it does not lie with defendant here who has receivedconsideration for his
promise to do the work “to say that his own performance would not bebeneficial to the
plaintiff[s]” (Chamberlain v. Parker, supra, p. 572).
Defendant’s completed performance would not have involved undoing what in good faith
wasdone improperly but only doing what was promised and left undone. That theburdens of
performance were heavier than anticipated and the cost of completion disproportionateto the end
to be obtained does not, without more, alter the rule that the measure ofplaintiffs’ damage is the
cost of completion. Disparity in relative economic benefits is not theequivalent of “economic
waste” which will invoke the rule in Jacob & Youngs, Inc. v. Kent. Moreover, faced with the
jury’s finding thatthe reasonable cost of removing the large concrete and stone walls and other
structures extendingabove grade was $90,000, defendant can hardly assert that he has rendered
substantial**534 performance of the contract or that what he left unfinished was “of trivial or
inappreciableimportance” ( Jacob & Youngs, Inc. v. Kent. Finally,defendant, instead of
attempting in good faith to complete the removal of the undergroundstructures, contended that he
was not obliged by the contract to do so and, thus, cannotclaim to be a “transgressor whose
default is unintentional and trivial*325 [and who] may hopefor mercy if he will offer atonement
for his wrong” ( Jacob & Youngs, Inc. v. Kent). We conclude, then, that the proof pertaining to
the value of plaintiffs’ property was properly rejected and the jury correctly charged on damages.
The judgment and order should be affirmed.
Judgment and Order unanimously affirmed with costs.
The following famous case actually arose as a tort claim. However, in resolving this dispute,
Judge Richard A. Posner applied the famous foreseeability rule for Hadley v. Baxendale. An
excellent appreciation of the opinion is Thomas J. Miles, “Posner on Economic Loss in Tort:
EVRA Corp. v. Swiss Bank.” 74 U. Chi. L. Rev.1813 (2007). The case makes an eloquent case
for applying the rule from Hadley v. Baxendale to a tort claim. The limitation of damages to
those that are reasonably foreseeable is a species of mitigation.
In reading this case you should note that Evra Corp. is the successor to Hyman-Michaels.
11
Web Notes – Sixth Edition
Cooter & Ulen
EVRA CORPORATION v. SWISS BANK CORPORATION
673 F.2d 951 (7th Cir. 1982)
Posner, Circuit Judge.
The question – one of first impression-in this diversity case – is the extent of a bank’s
liability forfailure to make a transfer of funds when requested by wire to do so. The essential
facts are undisputed.
In 1972 Hyman-Michaels Company, a large Chicago dealer in scrap metal, enteredinto a
two-year contract to supply steel scrap to a Brazilian corporation. Hyman-Michaelschartered a
ship, the Pandora, to carry the scrap to Brazil. The charter was for one year, withan option to
extend the charter for a second year; specified a fixed daily rate of pay for thehire of the ship
during both the initial and the option period, payable semi-monthly “in advance”;and provided
that if payment was not made on time the Pandora’s owner could cancelthe charter. Payment
was to be made by deposit to the owner’s account in the Banque de Pariset des Pays-Bas (Suisse)
in Geneva, Switzerland.
The usual method by which Hyman-Michaels, in Chicago, got the payments to the Banque
deParis in Geneva was to request the Continental Illinois National Bank and Trust Company of
Chicago, where it had an account, to make a wire transfer of funds. Continental would
debitHyman-Michaels’ account by the amount of the payment and then send a telex to its
Londonoffice for retransmission to its correspondent bank in Geneva-Swiss Bank CorporationaskingSwiss Bank to deposit this amount in the Banque de Paris account of the Pandora’s
owner.The transaction was completed by the crediting of Swiss Bank’s account at Continental by
thesame amount.
When Hyman-Michaels chartered the Pandora in June 1972, market charter rates were
verylow, and it was these rates that were fixed in the charter for its entire term – two years if
Hyman-Michaels exercised its option. Shortly after the agreement was signed, however,
charterrates began to climb and by October 1972 they were much higher than they had been in
June.The Pandora’s owners were eager to get out of the charter if they could. At the end of
Octoberthey thought they had found a way, for the payment that was due in the Banque de
Parison October 26 had not arrived by October 30, and on that day the Pandora’s owner
notifiedHyman-Michaels that it was canceling the charter because of the breach of the payment
term.Hyman-Michaels had mailed a check for the October 26 installment to the Banque de
Parisrather than use the wire-transfer method of payment. It had done this in order to have the
useof its money for the period that it *953 would take the check to clear, about two weeks.
Butthe check had not been mailed in Chicago until October 25 and of course did not
reachGeneva on the twenty-sixth.
When Hyman-Michaels received notification that the charter was being canceled, it
immediatelywired payment to the Banque de Paris, but the Pandora’s owner refused to accept it
andinsisted that the charter was indeed canceled. The matter was referred to arbitration in
accordancewith the charter. On December 5, 1972, the arbitration panel ruled in favor of HymanMichaels. …
Hyman-Michaels went back to making the charter payments by wire transfer. On the
morningof April 25, 1973, it telephoned Continental Bank and requested it to transfer $27,000 to
theBanque de Paris account of the Pandora’s owner in payment for the charter hire period
fromApril 27 to May 11, 1973. Since the charter provided for payment “in advance,” this
paymentarguably was due by the close of business on April 26. The requested telex went out to
12
Web Notes – Sixth Edition
Cooter & Ulen
Continental’sLondon office on the afternoon of April 25, which was nighttime in England.
Earlythe next morning a telex operator in Continental’s London office dialed, as
Continental’sChicago office had instructed him to do, Swiss Bank’s general telex number, which
rings inthe bank’s cable department. But that number was busy, and after trying unsuccessfully
for anhour to engage it, the Continental telex operator dialed another number, that of a machine
inSwiss Bank’s foreign exchange department, which he had used in the past when the
generalnumber was engaged. We know this machine received the telexed message because it
signaledthe sending machine at both the beginning and end of the transmission that the telex was
beingreceived. Yet Swiss Bank failed to comply with the payment order, and no transfer of
fundswas made to the account of the Pandora’s owner in the Banque de Paris.
No one knows exactly what went wrong. One possibility is that the receiving telex
machinehad simply run out of paper, in which event it would not print the message although it
had receivedit. Another is that whoever took the message out of the machine after it was
printedfailed to deliver it to the banking department. Unlike the machine in the cable department
thatthe Continental telex operator had originally tried to reach, the machines in the foreign
exchangedepartment were operated by junior foreign exchange dealers rather than by
professionaltelex operators, although Swiss Bank knew that messages intended for other
departmentswere sometimes diverted to the telex machines in the foreign exchange department.
At 8:30 a.m. the next day, April 27, Hyman-Michaels in Chicago received a telex from
thePandora’s owner stating that the charter was canceled because payment for the April 27May11 charter period had not been made. Hyman-Michaels called over to Continental and
toldthem to keep trying to effect payment through Swiss Bank even if the Pandora’s owner
rejectedit. … Hyman-Michaels did not attempt to wire the money directly to the Banque de Paris
as it had doneon the occasion of its previous default. Days passed while the missing telex
message washunted unsuccessfully. Finally Swiss Bank suggested to Continental that it
retransmit the telexmessage to the machine in the *954 cable department and this was done on
May 1. The nextday Swiss Bank attempted to deposit the $27,000 in the account of the
Pandora’s owner at theBanque de Paris but the payment was refused.
Again the arbitrators were convened and rendered a decision. … The arbitration panel
concluded, reluctantly but unanimously,that this time the Pandora’s owner was entitled to cancel
the agreement. The arbitrationdecision was confirmed by a federal district court in New York.
Hyman-Michaels then brought this diversity action against Swiss Bank, seeking to recover
itsexpenses in the second arbitration proceeding plus the profits that it lost because of the
cancellationof the charter. The contract by which Hyman-Michaels had agreed to ship scrap
steelto Brazil had been terminated by the buyer in March 1973 and Hyman-Michaels had
promptlysubchartered the Pandora at market rates, which by April 1973 were double the rates
fixed inthe charter. Its lost profits are based on the difference between the charter and
subcharterrates.
Swiss Bank impleaded Continental Bank as a third-party defendant, asking that if it should
beordered to pay Hyman-Michaels, then Continental should be ordered to indemnify it. …
The case was tried to a district judge without a jury. In his decision, 522 F.Supp.
820(N.D.Ill.1981), he first ruled that the substantive law applicable to Hyman-Michaels’
claimagainst Swiss Bank was that of Illinois, rather than Switzerland as urged by Swiss Bank,
andthat Swiss Bank had been negligent and under Illinois law was liable to Hyman-Michaels for
$2.1 million in damages. This figure was made up of about $16,000 in arbitration expensesand
the rest in lost profits on the subcharter of the Pandora. … The casecomes to us on Swiss Bank’s
13
Web Notes – Sixth Edition
Cooter & Ulen
appeal from the judgment in favor of Hyman-Michaels and fromthe dismissal of Swiss Bank’s
claim against Continental Bank, and on Hyman-Michaels’ appealfrom the dismissal of its
counterclaim against Continental Bank.
…
When a bank fails to make a requested transfer of funds, this can cause two kinds of
loss.First, the funds themselves or interest on them may be lost, and of course the fee paid for
thetransfer, having bought nothing, becomes a loss item. These are “direct” (sometimes called
“general”) damages. Hyman-Michaels is not seeking any direct damages in this case and
apparentlysustained none. It did not lose any part of the $27,000; although its account
withContinental Bank was debited by this amount prematurely, it was not an interest-bearing
accountso Hyman-Michaels lost no interest; and Hyman-Michaels paid no fee either to
Continentalor to Swiss Bank for the aborted transfer. A second type of loss, which either the
payoror the payee may suffer, is a dislocation in one’s business triggered by the failure to pay.
Swiss Bank’s failure to transfer funds to the Banque de Paris when requested to do so by
ContinentalBank set off a chain reaction which resulted in an arbitration proceeding that
wascostly to Hyman-Michaels and in the cancellation of a highly profitable contract. It is
thosecosts and lost profits – “consequential” or, as they are sometimes called, “special” damages
– thatHyman-Michaels seeks in this lawsuit, and recovered below. It is conceded that if HymanMichaels was entitled to consequential damages, the district court measured them correctly.
The only issue is whether it was entitled to consequential damages.If a bank loses a check, its
liability is governed by Article 4 of the Uniform CommercialCode, which precludes
consequential damages unless the bank is acting in bad faith. SeeIll.Rev.Stat. ch. 26, s 4-103(5).
If Article 4 applies to this transaction, Hyman-Michaels cannotrecover the damages that it seeks,
because Swiss Bank was not acting in bad faith. Maybethe language of Article 4 could be
stretched to include electronic fund transfers, see section4-102(2), but they were not in the
contemplation of the draftsmen. For purposes of this casewe shall assume, … that Article 4 is
inapplicable, and apply commonlaw principles instead.
Hadley v. Baxendale, 9 Ex. 341, 156 Eng.Rep. 145 (1854), is the leading common law case
onliability for consequential damages caused by failure or delay in carrying out a
commercialundertaking. The engine shaft in plaintiffs’ corn mill had broken, and they hired the
defendants,a common carrier, to transport the shaft to the manufacturer, who was to make a new
oneusing the broken shaft as a model. The carrier failed to deliver the shaft within the time
promised.
With the engine shaft out of service the mill was shut down. The plaintiffs sued the
defendantsfor the lost profits of the mill during the additional period that it was shut down
becauseof the defendants’ breach of their promise. The court held that the lost profits were not
aproper item of damages, because “in the great multitude of cases of millers sending off
brokenshafts to third persons by a carrier under ordinary circumstances, such consequences (the
stoppageof the mill and resulting loss of profits) would not, in all probability, have occurred;
andthese special circumstances were here never communicated by the plaintiffs to the
defendants.” 9 Ex. at 356, 156 Eng.Rep. at 151.
The rule of Hadley v. Baxendale-that consequential damages will not be awarded unless
thedefendant was put on notice of the special circumstances giving rise to *956 them-has
beenapplied in many Illinois cases, and Hadley cited approvingly. See, e.g., …Siegel v. Western
Union Tel. Co., 312Ill.App. 86, 92-93, 37 N.E.2d 868, 871 (1941) … In Siegel, the plaintiff had
delivered$200 to Western Union with instructions to transmit it to a friend of the plaintiff’s. The
14
Web Notes – Sixth Edition
Cooter & Ulen
moneywas to be bet (legally) on a horse, but this was not disclosed in the instructions. Western
Unionmisdirected the money order and it did not reach the friend until several hours after therace
had taken place. The horse that the plaintiff had intended to bet on won and would havepaid
$1650 on the plaintiff’s $200 bet if the bet had been placed. He sued Western Union forhis
$1450 lost profit, but the court held that under the rule of Hadley v. Baxendale WesternUnion
was not liable, because it “had no notice or knowledge of the purpose for which themoney was
being transmitted.” 312 Ill.App. at 93, 37 N.E.2d at 871.
The present case is similar, though Swiss Bank knew more than Western Union knew
inSiegel; it knew or should have known, from Continental Bank’s previous telexes, that HymanMichaels was paying the Pandora Shipping Company for the hire of a motor vessel
namedPandora. But it did not know when payment was due, what the terms of the charter were,
orthat they had turned out to be extremely favorable to Hyman-Michaels. And it did not
knowthat Hyman-Michaels knew the Pandora’s owner would try to cancel the charter, and
probablywould succeed, if Hyman-Michaels was ever again late in making payment, or that
despitethis peril Hyman-Michaels would not try to pay until the last possible moment and in
theevent of a delay in transmission would not do everything in its power to minimize the
consequencesof the delay. Electronic funds transfers are not so unusual as to automatically
placea bank on notice of extraordinary consequences if such a transfer goes awry. Swiss Bank
didnot have enough information to infer that if it lost a $27,000 payment order it would face a
liability in excess of $2 million. …
It is true that in both Hadley and Siegel there was a contract between the parties and here
therewas none. We cannot be certain that the Illinois courts would apply the principles of
thosecases outside of the contract area. As so often in diversity cases, there is an irreducible
amountof speculation involved in attempting to predict the reaction of a state’s courts to a new
issue.The best we can do is to assume that the Illinois courts would look to the policies
underlyingcases such as Hadley and Siegel and, to the extent they found them pertinent, would
applythose cases here. …
…
Siegel, we conclude, is authority for holding that Swiss Bank is not liable for the
consequencesof negligently failing to transfer Hyman-Michaels’ funds to Banque de Paris;
reasonfor such a holding is found in the animating principle of Hadley v. Baxendale, which is
thatthe costs of the untoward consequence of a course of dealings should be borne by that
partywho was able to avert the consequence at least cost and failed to do so. In Hadley the
untowardconsequence was the shutting down of the mill. The carrier could have avoided it by
deliveringthe engine shaft on time. But the mill owners, as the court noted, could have avoidedit
simply by having a spare shaft. 9 Ex. at 355-56, 156 Eng.Rep. at 151. Prudence requiredthat they
have a spare shaft anyway, since a replacement could not be obtained at once even ifthere was no
undue delay in carting the broken shaft to and the replacement shaft from themanufacturer. The
court refused to imply a duty on the part of the carrier to guarantee the millowners against the
consequences of their own lack of prudence, though of course if the partieshad stipulated for
such a guarantee the court would have enforced it. The notice requirementof Hadley v.
Baxendale is designed to assure that such an improbable guarantee really is intended.
This case is much the same, though it arises in a tort rather than a contract setting. HymanMichaels showed a lack of prudence throughout. It was imprudent for it to mail in Chicago
aletter that unless received the next day in Geneva would put Hyman-Michaels in breach of
acontract that was very profitable to it and that the other party to the contract had every interestin
15
Web Notes – Sixth Edition
Cooter & Ulen
canceling. It was imprudent thereafter for Hyman-Michaels, having narrowly avoided
cancellationand having (in the words of its appeal brief in this court) been “put ... on notice
thatthe payment provision of the Charter would be strictly enforced thereafter,” to wait till
arguablythe last day before payment was due to instruct its bank to transfer the necessary
fundsoverseas. And it was imprudent in the last degree for Hyman-Michaels, when it received
noticeof cancellation on the last possible day payment was due, to fail to pull out all the stops
toget payment to the Banque de Paris on that day, and instead to dither while Continental
andSwiss Bank wasted five days looking for the lost telex message. Judging from the obvious
reluctancewith which the arbitration panel finally decided to allow the Pandora’s owner to
cancelthe charter, it might have made all the difference if Hyman-Michaels had gotten paymentto
the Banque de Paris by April 27 or even by Monday, April 30, rather than allowed things toslide
until May 2.
This is not to condone the sloppy handling of incoming telex messages in Swiss Bank’s
foreigndepartment. But Hyman-Michaels is a sophisticated business enterprise. It knew orshould
have known that even the Swiss are not infallible; that messages sometimes get lost ordelayed in
transit among three banks, two of them located 5000 miles apart, even when all thebanks are
using reasonable care; and that therefore it should take its own precautions againstthe
consequences-best known to itself-of a mishap that might not be due to anyone’s negligence.
…
No other issues need be decided. The judgment in favor of Hyman-Michaels against
SwissBank is reversed with directions to enter judgment for Swiss Bank. The judgment in favor
ofContinental Bank on Swiss Bank’s third-party complaint is vacated with instructions to
dismissthat complaint as moot. The judgment dismissing Continental’s cross-claim against
Hyman-Michaels as moot, and the judgment in favor of Continental on Hyman-Michaels’
counterclaim,are affirmed. The costs of the appeals shall be borne by Hyman-Michaels (Evra
Corporation).
SO ORDERED.
We very briefly mention the issue of mitigation of loss from nonperformance in Question
9.17 in the text. It is a shame that we could not spend more time on this matter in the text. There
are fascinating economic issues here, and many of them are illustrated in this famous case. Note
that in both the Restatement (Second) of Contracts and the Uniform Commercial Code this duty
requires the innocent party only to take reasonable steps to see that the losses from
nonperformance do not increase. A classic article on the topic is Charles Goetz & Robert E.
Scott, “The Mitigation Principle: Toward a General Theory of Contractual Obligation,” 69 Va. L.
Rev. 967 (1983).
ROCKINGHAM COUNTY v. LUTEN BRIDGE CO.
35 F.2d 301 (4th Cir. 1929)
Parker, Circuit Judge.
This was an action at law instituted in the court below by the Luten Bridge Company,
asplaintiff, to recover of Rockingham county, North Carolina, an amount alleged to be due
16
Web Notes – Sixth Edition
Cooter & Ulen
undera contract, but contends that notice of cancellation was given the bridge company beforethe
erection of the bridge was commenced, and that it is liable only for the damages which
thecompany would have sustained, if it had abandoned construction at that time. The judge
belowrefused to strike out an answer filed by certain members of the board of commissioners of
thecounty, admitting liability in accordance with the prayer of the complaint, allowed this
pleadingto be introduced in evidence as the answer of the county, excluded evidence offered by
thecounty in support of its contentions as to notice of cancellation and damages, and instructed
averdict for plaintiff for the full amount of its claim. From judgment on this verdict the
countyhas appealed.
The facts out of which the case arises, as shown by the affidavits and offers of proof
appearingin the record, are as follows: On January 7, 1924, the board of commissioners of
Rockinghamcounty voted to award to plaintiff a contract for the construction of the bridge in
controversy.Three of the five commissioners favored the awarding of the contract and two
opposedit. Much feeling was engendered over the matter, with the result that on February 11,
1924,W. K. Pruitt, one of the commissioners who had voted in the affirmative, sent his
resignationto the clerk of the superior court of the county. The clerk received this resignation on
the sameday, and immediately accepted same and noted his acceptance thereon. Later in the day,
Pruittcalled him over the telephone and stated that he wished to withdraw the resignation, and
latersent him written notice*303 to the same effect. The clerk, however, paid no attention to the
attemptedwithdrawal, and proceeded on the next day to appoint one W. W. Hampton as a
memberof the board to succeed him.
After his resignation, Pruitt attended no further meetings of the board, and did nothing
furtheras a commissioner of the county. Likewise Pratt and McCollum, the other two members of
theboard who had voted with him in favor of the contract, attended no further meetings.
Hampton,on the other hand, took the oath of office immediately upon his appointment and
enteredupon the discharge of the duties of a commissioner. He met regularly with the two
remainingmembers of the board, Martin and Barber, in the courthouse at the county seat, and
with themattended to all of the business of the county. Between the 12th of February and the
firstMonday in December following, these three attended, in all, 25 meetings of the board.
At one of these meetings, a regularly advertised called meeting held on February 21st, a
resolutionwas unanimously adopted declaring that the contract for the building of the bridge
wasnot legal and valid, and directing the clerk of the board to notify plaintiff that it refused to
recognizesame as a valid contract, and that plaintiff should proceed no further thereunder.
Thisresolution also rescinded action of the board theretofore taken looking to the construction of
ahard-surfaced road, in which the bridge was to be a mere connecting link. The clerk duly senta
certified copy of this resolution to plaintiff.
At the regular monthly meeting of the board on March 3d, a resolution was passed
directingthat plaintiff be notified that any work done on the bridge would be done by it at its own
riskand hazard, that the board was of the opinion that the contract for the construction of
thebridge was not valid and legal, and that, even if the board were mistaken as to this, it did
notdesire to construct the bridge, and would contest payment for same if constructed. A copy
ofthis resolution was also sent to plaintiff. At the regular monthly meeting on April 7th, a
resolution was passed, reciting that the board had been informed that one of its members was
privately insisting that the bridge be constructed. It repudiated this action on the part of
themember and gave notice that it would not be recognized. At the September meeting, a
resolutionwas passed to the effect that the board would pay no bills presented by plaintiff or
17
Web Notes – Sixth Edition
Cooter & Ulen
anyone connected with the bridge. At the time of the passage of the first resolution, very
littlework toward the construction of the bridge had been done, it being estimated that the total
costof labor done and material on the ground was around $1,900; but, notwithstanding the
repudiationof the contract by the county, the bridge company continued with the work of
construction.
On November 24, 1924, plaintiff instituted this action against Rockingham county,
andagainst Pruitt, Pratt, McCollum, Martin, and Barber, as constituting its board of
commissioners.
Complaint was filed, setting forth the execution of the contract and the doing of work
byplaintiff thereunder, and alleging that for work done up until November 3, 1924, the
countywas indebted in the sum of $18,301.07. On November 27th, three days after the filing of
thecomplaint, and only three days before the expiration of the term of office of the members
ofthe old board of commissioners, Pruitt, Pratt, and McCollum met with an attorney at thecounty
seat, and, without notice to or consultation with the other members of the board, so faras appears,
had the attorney prepare for them an answer admitting the allegations of the complaint.
…
As the county now admits the execution and validity of the contract, and the breach on
itspart, the ultimate question in the case is one as to the measure of plaintiff’s recovery, and
theexceptions must be considered with this in mind. Upon these exceptions, three principal
questionsarise for our consideration, viz., (1) Whether the answer filed by Pruitt, Pratt, and
McCollum was the answer of the county. If it was, the lower court properly refused to strike
itout, and properly admitted it in evidence. (2) Whether, in the light of the evidence offered
andexcluded, the resolutions to which we have referred, and the notices sent pursuant thereto,
areto be deemed action on the part of the county. If they are not, the county has nothing
uponwhich to base its position as to minimizing damages, and the evidence offered was
properlyexcluded. And (3) whether plaintiff, if the notices are to be deemed action by the county,
canrecover under the contract for work done after they were received, or is limited to the
recoveryof damages for breach of contract as of that date.
…
Coming, then, to the third question – i.e., as to the measure of plaintiff’s recovery – we do
notthink that, after the county had given notice, while the contract was still executory, that it
didnot desire the bridge built and would not pay for it, plaintiff could proceed to build it and
recoverthe contract price. It is true that the county had no right to rescind the contract, and
thenotice given plaintiff amounted to a breach on its part; but, after plaintiff had received
noticeof the breach, it was its duty to do nothing to increase the damages flowing therefrom. If
Aenters into a binding contract to build a house for B, B, of course, has no right to rescind
thecontract without A’s consent. But if, before the house is built, he decides that he does not
wantit, and notifies A to that effect, A has no right to proceed with the building and thus pile
updamages. His remedy is to treat the contract as broken when he receives the notice, and suefor
the recovery of such damages, as he may have sustained from the breach, including anyprofit
which he would have realized upon performance, as well as any other losses which mayhave
resulted to him. In the case at bar, the county decided not to build the road of which thebridge
was to be a part, and did not build it. The bridge, built in the midst of the forest, is ofno value to
the county because of this change of circumstances. When, therefore, the countygave notice to
the plaintiff that it would not proceed with the project, plaintiff should have desistedfrom further
work. It had no right thus to pile up damages by proceeding with the erectionof a useless bridge.
18
Web Notes – Sixth Edition
Cooter & Ulen
The contrary view was expressed by Lord Cockburn in Frost v. Knight, L.R. 7 Ex. 111, but,
aspointed out by Prof. Williston (Williston on Contracts, vol. 3, p. 2347), it is not in
harmonywith the decisions in this country. The American rule and the reasons supporting it are
wellstated by Prof. Williston as follows:
There is a line of cases running back to 1845 which holds that, after an absolute repudiation or
refusal to perform by one party to a contract, the other party cannot continue to perform and
recover damages based on full performance. This rule is only a particular application of the
general rule of damages that a plaintiff cannot hold a defendant liable for damages which need
not have been incurred; or, as it is often stated, the plaintiff must, so far as he can without loss to
himself, mitigate the damages caused by the defendant’s wrongful act. The application of this rule
to the matter in question is obvious. If a man engages to have work done, and afterwards
repudiates his contract before the work has been begun or when it has been only partially done, it
is inflicting damage on the defendant without benefit to the plaintiff to allow the latter to insist on
proceeding with the contract. The work may be useless to the defendant, and yet he would be
forced to pay the full contract price. On *308 the other hand, the plaintiff is interested only in the
profit he will make out of the contract. If he receives this it is equally advantageous for him to use
his time otherwise.
…
Our conclusion, on the whole case, is that there was error in failing to strike out the answer
ofPruitt, Pratt, and McCollum, and in admitting same as evidence against the county, in
excludingthe testimony offered by the county to which we have referred, and in directing a
verdictfor plaintiff. The judgment below will accordingly be reversed, and the case remanded for
anew trial.
Reversed.
Finally, here is a case that is not about damages but raises some other issues with which
Chapter 9 will deal – specifically, unconscionability. The issue is a “forum-selection clause” – a
clause that specifies where any dispute arising under the contract will be heard. (There are also
common contract clauses that specify what law will apply in the event of a dispute, whether the
dispute must be put to arbitration (and where and before whom), and so on.) The
unconscionability issue is whether these clauses work such a significant disadvantage on one of
the parties – in this instance, the customers – as to amount to unconscionable advantage-taking.
This controversy between a cruise line and some customers of the line went to the U.S.
Supreme Court because the governing law is admiralty law.
CARNIVAL CRUISE LINES, INC., v. SHUTE
499 U.S. 585, 111 S.Ct. 1522 (1991).
*587 Justice Blackmun delivered the opinion of the Court.
In this admiralty case we primarily consider whether the United States Court of Appealsfor
the Ninth Circuit correctly refused to enforce a forum-selection clause contained in ticketsissued
by petitioner Carnival Cruise Lines, Inc., to respondents Eulala and Russel Shute.
19
Web Notes – Sixth Edition
Cooter & Ulen
I
The Shutes, through an Arlington, Wash., travel agent, purchased passage for a 7-daycruise
on petitioner’s ship, the Tropicale. Respondents paid the fare to the agent who forwardedthe
payment to petitioner’s headquarters in Miami, Fla. Petitioner then prepared the ticketsand sent
them to respondents in the State of Washington. The face of each ticket, at its lefthandlower
corner, contained this admonition:
“SUBJECT TO CONDITIONS OF CONTRACT ON LAST PAGES IMPORTANT!
PLEASE READ CONTRACT-ON LAST PAGES 1, 2, 3” App. 15.
The following appeared on “contract page 1” of each ticket:
“TERMS AND CONDITIONS OF PASSAGE CONTRACT TICKET
…
“3. (a) The acceptance of this ticket by the person or persons named hereon as passengers shall be
deemed to be an acceptance and agreement by each of them of all of the terms and conditions of
this Passage Contract Ticket.
…
“8. It is agreed by and between the passenger and the Carrier that all disputes and matters
whatsoever arising under, in connection with or incident to this Contract *588 shall be litigated, if
at all, in and before a Court located in the State of Florida, U.S.A., to the exclusion of the Courts
of any other state or country.” Id., at 16.
The last quoted paragraph is the forum-selection clause at issue.
II
Respondents boarded the Tropicale in Los Angeles, Cal. The ship sailed to Puerto
Vallarta,Mexico, and then returned to Los Angeles. While the ship was in international waters
offthe Mexican coast, respondent Eulala Shute was injured when she slipped on a deck mat
duringa guided tour of the ship’s galley. Respondents filed suit against petitioner in the
UnitedStates District Court for the Western District of Washington, claiming that Mrs. Shute’s
injurieshad been caused by the negligence of Carnival Cruise Lines and its employees. …
[The Court then discusses some procedural matters.]
*589 Turning to the forum-selection clause, the Court of Appeals acknowledged that acourt
concerned with the enforceability of such a clause must begin its analysis with The Bremenv.
Zapata Off-Shore Co., 407 U.S. 1, 92 S.Ct. 1907, 32 L.Ed.2d 513 (1972), where thisCourt held
that forum-selection clauses, although not “historically ... favored,” are “primafacie valid.”…
The appellate court concludedthat the forum clause should not be enforced because it “was not
freely bargained for.” … As an “independent justification” for refusing to enforce the clause, the
Court ofAppeals noted that there was evidence in the record to indicate that “the Shutes are
physicallyand financially incapable of pursuing this litigation in Florida” and that the
enforcement of theclause would operate to deprive them of their day in court and thereby
contravene this Court’sholding in The Bremen.
…
III
20
Web Notes – Sixth Edition
Cooter & Ulen
We begin by noting the boundaries of our inquiry. First, this is a case in admiralty,
andfederal law governs the enforceability of the forum-selection clause we scrutinize. … Second,
we do not address the question whether respondents had sufficientnotice of the forum clause
before entering the contract for passage. Respondents essentially have conceded that they had
notice of the forum-selection provision. …
**1526 Within this context, respondents urge that the forum clause should not be
enforcedbecause, contrary to this Court’s teachings in The Bremen, the clause was not the
product ofnegotiation, and enforcement effectively would deprive respondents of their day in
court. …
IV
A
Both petitioner and respondents argue vigorously that the Court’s opinion in The
Bremengoverns this case, and each side purports to find ample support for its position in
that*591 opinion’s broad-ranging language. This seeming paradox derives in large part from
keyfactual differences between this case and The Bremen, differences that preclude an
automaticand simple application of The Bremen’s general principles to the facts here.
In The Bremen, this Court addressed the enforceability of a forum-selection clause in
acontract between two business corporations. An American corporation, Zapata, made a
contractwith Unterweser, a German corporation, for the towage of Zapata’s oceangoing
drillingrig from Louisiana to a point in the Adriatic Sea off the coast of Italy. The
agreementprovided that any dispute arising under the contract was to be resolved in the London
Court ofJustice. After a storm in the Gulf of Mexico seriously damaged the rig, Zapata ordered
Unterweser’sship to tow the rig to Tampa, Fla., the nearest point of refuge. Thereafter, Zapata
suedUnterweser in admiralty in federal court at Tampa. Citing the forum clause,
Unterwesermoved to dismiss. The District Court denied Unterweser’s motion, and the Court of
Appealsfor the Fifth Circuit, sitting en banc on rehearing, and by a sharply divided vote,
affirmed. …
This Court vacated and remanded, stating that, in general, “a freely negotiated private
internationalagreement, unaffected by fraud, undue influence, or overweening bargainingpower,
such as that involved here, should be given full effect.”
…
In applying The Bremen, the Court of Appeals in the present litigation took note of
theforegoing “reasonableness” factors and rather automatically decided that the forumselectionclause was unenforceable because, **1527 unlike the parties in The Bremen,
respondents arenot business persons and did not negotiate the terms of the clause with petitioner.
Alternatively,the Court of Appeals ruled that the clause should not be enforced because
enforcementeffectively would deprive respondents of an opportunity to litigate their claim
against petitioner.
The Bremen concerned a “far from routine transaction between companies of two
differentnations contemplating the tow of an extremely costly piece of equipment from
Louisianaacross the Gulf of Mexico and the Atlantic Ocean, through the Mediterranean Sea to its
finaldestination in the Adriatic Sea.”[] These facts suggest that, evenapart from the evidence of
negotiation regarding the forum clause, it was entirely reasonablefor the Court in The *593
Bremen to have expected Unterweser and Zapata to have negotiatedwith care in selecting a
forum for the resolution of disputes arising from their special towingcontract.
21
Web Notes – Sixth Edition
Cooter & Ulen
In contrast, respondents’ passage contract was purely routine and doubtless nearly identicalto
every commercial passage contract issued by petitioner and most other cruise lines. … In this
context, it would beentirely unreasonable for us to assume that respondents – or any other cruise
passenger – would negotiate with petitioner the terms of a forum-selection clause in an ordinary
commercialcruise ticket. Common sense dictates that a ticket of this kind will be a form contract
the termsof which are not subject to negotiation, and that an individual purchasing the ticket will
nothave bargaining parity with the cruise line. …
In evaluating the reasonableness of the forum clause at issue in this case, we must refinethe
analysis of The Bremen to account for the realities of form passage contracts. As an initialmatter,
we do not adopt the Court of Appeals’ determination that a nonnegotiated forum-selectionclause
in a form ticket contract is never enforceable simply because it is not the subjectof bargaining.
Including a reasonable forum clause in a form contract of this kind well may bepermissible for
several reasons: First, a cruise line has a special interest in limiting the fora inwhich it potentially
could be subject to suit. Because a cruise ship typically carries passengersfrom many locales, it is
not unlikely that a mishap on a cruise could subject the cruise line tolitigation in several different
fora. … Additionally, a clause establishing ex ante the forumfor dispute resolution has the
salutary *594 effect of dispelling any confusion about wheresuits arising from the contract must
be brought and defended, sparing litigants the time andexpense of pretrial motions to determine
the correct forum and conserving judicial resourcesthat otherwise would be devoted to deciding
those motions. .... Finally, it stands to reason that passengerswho purchase tickets containing a
forum clause like that at issue in this case benefit inthe form of reduced fares reflecting the
savings that the cruise line enjoys by limiting the for a in which it may be sued. …
…
It bears emphasis that forum-selection clauses contained in form passage contracts aresubject
to judicial scrutiny for fundamental fairness. In this case, there is no indication that petitionerset
Florida as the forum in which disputes were to be resolved as a means of discouragingcruise
passengers from pursuing legitimate claims. Any suggestion of such a bad-faithmotive is belied
by two facts: Petitioner has its principal place of business in Florida, andmany of its cruises
depart from and return to Florida ports. Similarly, there is no evidence thatpetitioner obtained
respondents’ accession to the forum clause by fraud or overreaching. Finally,respondents have
conceded that they were given notice of the forum provision and,therefore, presumably retained
the option of rejecting the contract with impunity. In the casebefore us, therefore, we conclude
that the Court of Appeals erred in refusing to enforce theforum-selection clause.
….
The judgment of the Court of Appeals is reversed.
It is so ordered.
Justice STEVENS, with whom Justice MARSHALL joins, dissenting.
The Court prefaces its legal analysis with a factual statement that implies that a purchaserof a
Carnival Cruise Lines passenger ticket is fully and fairly notified about the existence ofthe
choice of forum clause in the fine print on the back of the ticket. [] Even ifthis implication were
accurate, I would disagree with the Court’s analysis. But, given theCourt’s preface, I begin my
dissent by noting that only the most meticulous passenger is likelyto become aware of the forumselection provision. I have therefore appended to this opinion afacsimile of the relevant text,
22
Web Notes – Sixth Edition
Cooter & Ulen
using the type size that actually appears in the ticket itself. Acareful reader will find the forumselection clause in the 8th of the 25 numbered paragraphs. [See the original opinion for the
reproduction.]
Of course, many passengers, like the respondents in this case will nothave an opportunity to
read paragraph 8 until they have actually purchased their tickets. Bythis point, the passengers
will already have accepted the condition set forth in paragraph16(a), which provides that “[t]he
Carrier shall not be liable to make any refund to passengersin respect of ... tickets wholly or
partly not used by a passenger.” Not knowing whether or notthat provision is legally enforceable,
I assume that the average passenger would accept therisk of having to file suit in Florida in the
event of an injury, rather than canceling-without arefund-a planned vacation at the last minute.
The fact that the cruise line can reduce its litigationcosts, and therefore its liability insurance
premiums, by forcing this choice on its passengersdoes not, in my opinion, suffice to render the
*598 provision reasonable. …
Even if passengers received prominent notice of the forum-selection clause before
theycommitted the cost of the cruise, I would remain persuaded that the clause was
unenforceableunder traditional principles of federal admiralty law and is “null and void” under
the terms ofLimitation of Vessel Owners Liability Act, ch. 521, 49 Stat. 1480, 46 U.S.C.App. §
183c,111 which was enacted in 1936 to invalidate expressly stipulations limiting shipowners’
liabilityfor negligence.
…
*600 Forum-selection clauses in passenger tickets involve the intersection of two strandsof
traditional contract law that qualify the general rule that courts will enforce the terms of
acontract as written. Pursuant to the first strand, courts traditionally have reviewed
withheightened scrutiny the terms of contracts of adhesion, form contracts offered on a take-orleave basis by a party with **1531 stronger bargaining power to a party with weakerpower.
Some commentators have questioned whether contracts of adhesion can justifiably beenforced at
all under traditional contract theory because the adhering party generally enters intothem without
manifesting knowing and voluntary consent to all their terms. [Citations omitted.]
The common law, recognizing that standardized form contracts account for a
significantportion of all commercial agreements, has taken a less extreme position and instead
subjectsterms in contracts of adhesion to scrutiny for reasonableness. Judge J. Skelly Wright set
outthe state of the law succinctly in Williams v. Walker-Thomas Furniture Co., 315, 319-320,
350 F.2d 445, 449-450 (1965) (footnotes omitted):
Ordinarily, one who signs an agreement without full knowledge of its terms might be held to
assume the risk that he has entered a one-sided bargain. But when a party of little bargaining
power, and hence little real choice, signs a commercially unreasonable contract with little or no
knowledge of its terms, it is hardly likely that his consent, or even an objective manifestation of
his *601 consent, was ever given to all of the terms. In such a case the usual rule that the terms of
the agreement are not to be questioned should be abandoned and the court should consider
whether the terms of the contract are so unfair that enforcement should be withheld.
The second doctrinal principle implicated by forum-selection clauses is the traditional
rule111 that “contractual provisions, which seek to limit the place or court in which an action
may ...be brought, are invalid as contrary to public policy.”… Although adherence to this general
rule has declined in recent years, particularly followingour decision in The Bremen v. Zapata
Off-Shore Co., 407 U.S. 1, 92 S.Ct. 1907, 32 L.Ed.2d513 (1972), the prevailing rule is still that
forum-selection clauses are not enforceable if theywere not freely bargained for, create
23
Web Notes – Sixth Edition
Cooter & Ulen
additional expense for one party, or deny one party aremedy. … A forum-selection clause in a
standardizedpassenger ticket would clearly have been unenforceable under the common law
beforeour decision in The Bremen, see 407 U.S., at 9, and n. 10, 92 S.Ct., at 1912-13, and n. 10,
and,in my opinion, remains unenforceable under the prevailing rule today.
The Bremen, which the Court effectively treats as controlling this case, had nothing to
sayabout stipulations printed on the back of passenger tickets. That case involved the
enforceabilityof a forum-selection clause in a freely negotiated international agreement between
twolarge corporations providing for the towage of a vessel from the Gulf of Mexico to the
AdriaticSea. The Court recognized that such towage agreements had generally been held
unenforceablein American*602 courts, but held that the doctrine of **1532 those cases did not
extendto commercial arrangements between parties with equal bargaining power.
…
The stipulation in the ticket that Carnival Cruise sold to respondents certainly lessens
orweakens their ability to recover for the slip and fall incident that occurred off the west coast
ofMexico during the cruise that originated and terminated in Los Angeles, California. It is safe to
assume that the witnesses – whether other passengers or members of the crew – can be
assembledwith less expense and inconvenience at a west coast forum than in a Florida
courtseveral thousand miles from the scene of the accident.
…[T]heplaintiffs in this case are not large corporations but individuals, and the added burden
on themof conducting a trial at the opposite end of the country is likely proportional to the
additionalcost to a large corporation of conducting a trial overseas.
Under these circumstances, the general prohibition against stipulations purporting “tolessen,
weaken, or avoid” the passenger’s right to a trial certainly should be construed to applyto the
manifestly unreasonable stipulation in these passengers’*605 tickets. Even without thebenefit of
the statute, I would continue to apply the general rule that prevailed prior to our decisionin The
Bremen to forum-selection clauses in passenger tickets.
I respectfully dissent.
Web Note 9.2 (p. 323)
For the representation of Table 9.2 as a decision tree, see our website.
24
Web Notes – Sixth Edition
Cooter & Ulen
Web Note 9.3 (p. 324)
Our website discusses some further issues having to do with stipulated damages, includes
an excerpt from a decision by Judge Posner in which he had to determine the
enforceability of a penalty clause, and of other remedies.
LAKE RIVER CORPORATION v. CARBORUNDUM COMPANY
769 F.2d 1284 (7th Cir. 1985)
POSNER, Circuit Judge.
This diversity suit between Lake River Corporation and Carborundum Company requires us
to consider questions of Illinois commercial law, and in particular to explore the fuzzy line
between penalty clauses and liquidated-damages clauses.
Carborundum manufactures "Ferro Carbo," an abrasive powder used in making steel. To
serve its midwestern customers better, Carborundum made a contract with Lake River by which
the latter agreed to provide distribution services in its warehouse in Illinois. Lake River would
receive Ferro Carbo in bulk from Carborundum, "bag" it, and ship the bagged product to
Carborundum's customers. The Ferro Carbo would remain Carborundum's property until
delivered to the customers.
Carborundum insisted that Lake River install a new bagging system to handle the contract. In
order to be sure of being able to recover the cost of the new system ($89,000) and make a profit
of 20 percent of the contract price, Lake River insisted on the following minimum-quantity
guarantee:
25
Web Notes – Sixth Edition
Cooter & Ulen
In consideration of the special equipment [i.e., the new bagging system] to be acquired and
furnished by LAKE-RIVER for handling the product, CARBORUNDUM shall, during the initial
three-year term of this Agreement, ship to LAKE-RIVER for bagging a minimum quantity of
[22,500 tons]. If, at the end of the three-year term, this minimum quantity shall not have been
shipped, LAKE-RIVER shall invoice CARBORUNDUM at the then prevailing rates for the
difference between the quantity bagged and the minimum guaranteed.
If Carborundum had shipped the full minimum quantity that it guaranteed, it would have
owed Lake River roughly $533,000 under the contract.
After the contract was signed in 1979, the demand for domestic steel, and with it the demand
for Ferro Carbo, plummeted, and Carborundum failed to ship the guaranteed amount. When the
contract expired late in 1982, Carborundum had shipped only 12,000 of the 22,500 tons it had
guaranteed. Lake River had bagged the 12,000 tons and had billed Carborundum for this
bagging, and Carborundum had paid, but by virtue of the formula in the minimum-guarantee
clause Carborundum still owed Lake River $241,000 — the contract price of $533,000 if the full
amount of Ferro Carbo had been shipped, minus what Carborundum had paid for the bagging of
the quantity it had shipped.
When Lake River demanded payment of this amount, Carborundum refused, on the ground
that the formula imposed a penalty. At the time, Lake River had in its warehouse 500 tons of
bagged Ferro Carbo, having a market value of $269,000, which it refused to release unless
Carborundum paid the $241,000 due under the formula. Lake River did offer to sell the bagged
product and place the proceeds in escrow until its dispute with Carborundum over the
enforceability of the formula was resolved, but Carborundum rejected the offer and trucked in
bagged Ferro Carbo from the East to serve its customers in Illinois, at an additional cost of
$31,000.
Lake River brought this suit for $241,000, which it claims as liquidated damages.
Carborundum counterclaimed for the value of the bagged Ferro Carbo when Lake River
impounded it and the additional cost of serving the customers affected by the impounding. The
theory of the counterclaim is that the impounding was a conversion, and not as Lake River
contends the assertion of a lien. The district judge, after a 1287*1287 bench trial, gave judgment
for both parties. Carborundum ended up roughly $42,000 to the good: $269,000 + $31,000$241,000-$17,000, the last figure representing prejudgment interest on Lake River's damages.
(We have rounded off all dollar figures to the nearest thousand.) Both parties have appealed.
The only issue that is not one of damages is whether Lake River had a valid lien on the
bagged Ferro Carbo that it refused to ship to Carborundum's customers — that, indeed, it holds
in its warehouse to this day. Although Ferro Carbo does not deteriorate with age, the domestic
steel industry remains in the doldrums and the product is worth less than it was in 1982 when
Lake River first withheld it. If Lake River did not have a valid lien on the product, then it
converted it, and must pay Carborundum the $269,000 that the Ferro Carbo was worth back then.
It might seem that if the minimum-guarantee clause was a penalty clause and hence
unenforceable, the lien could not be valid, and therefore that we should discuss the penalty issue
first. But this is not correct. If the contractual specification of damages is invalid, Lake River still
is entitled to any actual damages caused by Carborundum's breach of contract in failing to
deliver the minimum amount of Ferro Carbo called for by the contract. The issue is whether an
entitlement to damages, large or small, entitles the victim of the breach to assert a lien on goods
that are in its possession though they belong to the other party.
26
Web Notes – Sixth Edition
Cooter & Ulen
Lake River has not been very specific about the type of lien it asserts. We think it best
described as a form of artisan's lien, the "lien of the bailee, who does work upon or adds
materials to chattels...." Restatement of Security § 61, comment on clause (a), at p. 165 (1941).
Lake River was the bailee of the Ferro Carbo that Carborundum delivered to it, and it did work
on the Ferro Carbo — bagging it, and also storing it (storage is a service, too). If Carborundum
had refused to pay for the services that Lake River performed on the Ferro Carbo delivered to it,
then Lake River would have had a lien on the Ferro Carbo in its possession, to coerce payment.
Cf. National Bank of Joliet v. Bergeron Cadillac, Inc., 66 Ill.2d 140, 143-44, 5 Ill.Dec. 588, 589,
361 N.E.2d 1116, 1117 (1977). But in fact, when Lake River impounded the bagged Ferro
Carbo, Carborundum had paid in full for all bagging and storage services that Lake River had
performed on Ferro Carbo shipped to it by Carborundum. The purpose of impounding was to put
pressure on Carborundum to pay for services not performed, Carborundum having failed to ship
the Ferro Carbo on which those services would have been performed.
Unlike a contractor who, having done the work contracted for without having been paid, may
find himself in a box, owing his employees or suppliers money he does not have — money he
was counting on from his customer — Lake River was the victim of a breach of a portion of the
contract that remained entirely unexecuted on either side. Carborundum had not shipped the
other 10,500 tons, as promised; but on the other hand Lake River had not had to bag those
10,500 tons, as it had promised. It is not as if Lake River had bagged those tons, incurring heavy
costs that it expected to recoup from Carborundum, and then Carborundum had said, "Sorry, we
won't pay you; go ahead and sue us."
A lien is strong medicine; it clogs up markets, as the facts of this case show. Its purpose is to
provide an effective self-help remedy for one who has done work in expectation of payment and
then is not paid. The vulnerable position of such a person gives rise to "the artisan's privilege of
holding the balance for work done in the past." United States v. Toys of the World Club, Inc., 288
F.2d 89, 94 (2d Cir.1961) (Friendly, J.) (emphasis added). A lien is thus a device for preventing
unjust enrichment — not for forcing the other party to accede to your view of a contract dispute.
"The right to retain possession of the property to enforce a possessory lien continues until such
time as the charges 1288*1288 for such materials, labor and services are paid." Bull v. Mitchell,
114 Ill.App.3d 177, 181, 70 Ill.Dec. 138, 141, 448 N.E.2d 1016, 1019 (1983); cf. Ill.Rev.Stat. ch.
82, § 40. Since here the charges were paid before the lien was asserted, the lien was no good.
Lake River tries to compare its position to that of a conventional lien creditor by pointing out
that it made itself particularly vulnerable to a breach of contract by buying specialized equipment
at Carborundum's insistence, to the tune of $89,000, before performance under the contract
began. It says it insisted on the minimum guarantee in order to be sure of being able to amortize
this equipment over a large enough output of bagging services to make the investment
worthwhile. But the equipment was not completely useless for other contracts — Lake River
having in fact used it for another contract; it was not the major cost of fulfilling the contract; and
Lake River received almost $300,000 during the term of the contract, thus enabling it to amortize
much of the cost of the special equipment. Although Lake River may have lost money on the
contract (but as yet there is no proof it did), it was not in the necessitous position of a contractor
who completes his performance without receiving a dime and then is told by his customer to sue
for the price. The recognition of a lien in such a case is based on policies akin to those behind the
rule that a contract modification procured by duress will not be enforced. See, e.g., Selmer Co. v.
Blakeslee-Midwest Co., 704 F.2d 924 (7th Cir.1983). When as a practical matter the legal
remedy may be inadequate because it operates too slowly, self-help is allowed. But we can find
27
Web Notes – Sixth Edition
Cooter & Ulen
no case recognizing a lien on facts like these, no ground for thinking that the Illinois Supreme
Court would be the first court to recognize such a lien if this case were presented to it, and no
reason to believe that the recognition of such a lien would be a good thing. It would impede the
marketability of goods without responding to any urgent need of creditors.
Conrow v. Little, 115 N.Y. 387, 393, 22 N.E. 346, 347 (1889), on which Lake River relies
heavily because the lien allowed in that case extended to "money expended in the preparation of
instrumentalities," is not in point. The plaintiffs, dealers in paper, had made extensive deliveries
to the defendants for which they had received no payment. See id. at 390-91, 22 N.E. at 346. If
Lake River had bagged several thousand tons of Ferro Carbo without being paid anything, it
would have had a lien on the Ferro Carbo; and maybe — if Conrow is good law in Illinois, a
question we need not try to answer — the lien would have included not only the contract price
for the Ferro Carbo that Lake River had bagged but also the unreimbursed, unsalvageable cost of
the special bagging system that Lake River had installed. But that is not this case. Carborundum
was fully paid up and Lake River has made no effort to show how much if any money it stood to
lose because the bagging system was not fully amortized. The only purpose of the lien was to
collect damages which would have been unrelated to — and certainly exceeded — the
investment in the bagging system.
It is no answer that the bagging system should be presumed to have been amortized equally
over the life of the contract, and therefore to have been only half amortized when Carborundum
broke the contract. Amortization is an accounting device; it need not reflect cash flows. There is
no evidence that when the contract was broken, Lake River was out of pocket a cent in respect of
the bagging system, especially when we consider that the bagging system was still usable, and
was used to fulfill another contract.
The hardest issue in the case is whether the formula in the minimum-guarantee clause
imposes a penalty for breach of contract or is merely an effort to liquidate damages. Deep as the
hostility to penalty clauses runs in the common law, see Loyd, Penalties and Forfeitures, 29
Harv.L.Rev. 117 (1915), we still might be inclined to question, if we thought ourselves free to do
so, whether a modern court should refuse to enforce a penalty clause where the signator
1289*1289 is a substantial corporation, well able to avoid improvident commitments. Penalty
clauses provide an earnest of performance. The clause here enhanced Carborundum's credibility
in promising to ship the minimum amount guaranteed by showing that it was willing to pay the
full contract price even if it failed to ship anything. On the other side it can be pointed out that by
raising the cost of a breach of contract to the contract breaker, a penalty clause increases the risk
to his other creditors; increases (what is the same thing and more, because bankruptcy imposes
"deadweight" social costs) the risk of bankruptcy; and could amplify the business cycle by
increasing the number of bankruptcies in bad times, which is when contracts are most likely to
be broken. But since little effort is made to prevent businessmen from assuming risks, these
reasons are no better than makeweights.
A better argument is that a penalty clause may discourage efficient as well as inefficient
breaches of contract. Suppose a breach would cost the promisee $12,000 in actual damages but
would yield the promisor $20,000 in additional profits. Then there would be a net social gain
from breach. After being fully compensated for his loss the promisee would be no worse off than
if the contract had been performed, while the promisor would be better off by $8,000. But now
suppose the contract contains a penalty clause under which the promisor if he breaks his promise
must pay the promisee $25,000. The promisor will be discouraged from breaking the contract,
28
Web Notes – Sixth Edition
Cooter & Ulen
since $25,000, the penalty, is greater than $20,000, the profits of the breach; and a transaction
that would have increased value will be forgone.
On this view, since compensatory damages should be sufficient to deter inefficient breaches
(that is, breaches that cost the victim more than the gain to the contract breaker), penal damages
could have no effect other than to deter some efficient breaches. But this overlooks the earlier
point that the willingness to agree to a penalty clause is a way of making the promisor and his
promise credible and may therefore be essential to inducing some value-maximizing contracts to
be made. It also overlooks the more important point that the parties (always assuming they are
fully competent) will, in deciding whether to include a penalty clause in their contract, weigh the
gains against the costs — costs that include the possibility of discouraging an efficient breach
somewhere down the road — and will include the clause only if the benefits exceed those costs
as well as all other costs.
On this view the refusal to enforce penalty clauses is (at best) paternalistic — and it seems
odd that courts should display parental solicitude for large corporations. But however this may
be, we must be on guard to avoid importing our own ideas of sound public policy into an area
where our proper judicial role is more than usually deferential. The responsibility for making
innovations in the common law of Illinois rests with the courts of Illinois, and not with the
federal courts in Illinois. And like every other state, Illinois, untroubled by academic skepticism
of the wisdom of refusing to enforce penalty clauses against sophisticated promisors, see, e.g.,
Goetz & Scott, Liquidated Damages, Penalties and the Just Compensation Principle, 77
Colum.L.Rev. 554 (1977), continues steadfastly to insist on the distinction between penalties and
liquidated damages. See, e.g., Bauer v. Sawyer, 8 Ill.2d 351, 359-61, 134 N.E.2d 329, 333-34
(1956); Stride v. 120 West Madison Bldg. Corp., 132 Ill.App.3d 601, 605-06, 87 Ill.Dec. 790,
793, 477 N.E.2d 1318, 1321 (1985); Builder's Concrete Co. v. Fred Faubel & Sons, Inc., 58
Ill.App.3d 100, 107, 15 Ill.Dec. 517, 524, 373 N.E.2d 863, 869 (1978). To be valid under Illinois
law a liquidation of damages must be a reasonable estimate at the time of contracting of the
likely damages from breach, and the need for estimation at that time must be shown by reference
to the likely difficulty of measuring the actual damages from a breach of contract after the breach
occurs. If damages would be easy to determine then, or if the estimate greatly exceeds a
reasonable upper estimate 1290*1290 of what the damages are likely to be, it is a penalty. See,
e.g., M.I.G. Investments, Inc. v. Marsala, 92 Ill.App.3d 400, 405-06, 47 Ill.Dec. 265, 270, 414
N.E.2d 1381, 1386 (1981).
The distinction between a penalty and liquidated damages is not an easy one to draw in
practice but we are required to draw it and can give only limited weight to the district court's
determination. Whether a provision for damages is a penalty clause or a liquidated-damages
clause is a question of law rather than fact, Weiss v. United States Fidelity & Guaranty Co., 300
Ill. 11, 16, 132 N.E. 749, 751 (1921); M.I.G. Investments, Inc. v. Marsala, supra, 92 Ill.App.3d
400, 406, 47 Ill.Dec. 265, 270, 414 N.E.2d 1381, 1386, and unlike some courts of appeals we do
not treat a determination by a federal district judge of an issue of state law as if it were a finding
of fact, and reverse only if persuaded that clear error has occurred, though we give his
determination respectful consideration. See, e.g., Morin Bldg. Products Co. v. Baystone
Construction, Inc., 717 F.2d 413, 416-17 (7th Cir.1983); In re Air Crash Disaster Near Chicago,
701 F.2d 1189, 1195 (7th Cir.1983); 19 Wright, Miller & Cooper, Federal Practice and
Procedure § 4507, at pp. 106-110 (1982).
Mindful that Illinois courts resolve doubtful cases in favor of classification as a penalty, see,
e.g., Stride v. 120 West Madison Bldg. Corp., supra, 132 Ill.App.3d at 605, 87 Ill.Dec. at 793,
29
Web Notes – Sixth Edition
Cooter & Ulen
477 N.E.2d at 1321; Pick Fisheries, Inc. v. Burns Electronic Security Services, Inc., 35
Ill.App.3d 467, 472, 342 N.E.2d 105, 108 (1976), we conclude that the damage formula in this
case is a penalty and not a liquidation of damages, because it is designed always to assure Lake
River more than its actual damages. The formula — full contract price minus the amount already
invoiced to Carborundum — is invariant to the gravity of the breach. When a contract specifies a
single sum in damages for any and all breaches even though it is apparent that all are not of the
same gravity, the specification is not a reasonable effort to estimate damages; and when in
addition the fixed sum greatly exceeds the actual damages likely to be inflicted by a minor
breach, its character as a penalty becomes unmistakable. See M.I.G. Investments, Inc. v. Marsala,
supra, 92 Ill.App.3d at 405-06, 47 Ill.Dec. at 270, 414 N.E.2d at 1386; cf. Arduini v. Board of
Educ., 93 Ill.App.3d 925, 931-33, 49 Ill.Dec. 460, 465-66, 418 N.E.2d 104, 109-10 (1981), rev'd
on other grounds, 92 Ill.2d 197, 65 Ill.Dec. 281, 441 N.E.2d 73 (1982); 5 Corbin on Contracts §
1066 (1964). This case is within the gravitational field of these principles even though the
minimum-guarantee clause does not fix a single sum as damages.
Suppose to begin with that the breach occurs the day after Lake River buys its new bagging
system for $89,000 and before Carborundum ships any Ferro Carbo. Carborundum would owe
Lake River $533,000. Since Lake River would have incurred at that point a total cost of only
$89,000, its net gain from the breach would be $444,000. This is more than four times the profit
of $107,000 (20 percent of the contract price of $533,000) that Lake River expected to make
from the contract if it had been performed: a huge windfall.
Next suppose (as actually happened here) that breach occurs when 55 percent of the Ferro
Carbo has been shipped. Lake River would already have received $293,000 from Carborundum.
To see what its costs then would have been (as estimated at the time of contracting), first subtract
Lake River's anticipated profit on the contract of $107,000 from the total contract price of
$533,000. The difference — Lake River's total cost of performance — is $426,000. Of this,
$89,000 is the cost of the new bagging system, a fixed cost. The rest ($426,000-$89,000 =
$337,000) presumably consists of variable costs that are roughly proportional to the amount of
Ferro Carbo bagged; there is no indication of any other fixed costs. Assume, therefore, that if
Lake River bagged 55 percent of the contractually agreed quantity, it incurred in doing so 55
percent of its variable costs, or $185,000. 1291*1291 When this is added to the cost of the new
bagging system, assumed for the moment to be worthless except in connection with the contract,
the total cost of performance to Lake River is $274,000. Hence a breach that occurred after 55
percent of contractual performance was complete would be expected to yield Lake River a
modest profit of $19,000 ($293,000-$274,000). But now add the "liquidated damages" of
$241,000 that Lake River claims, and the result is a total gain from the breach of $260,000,
which is almost two and a half times the profit that Lake River expected to gain if there was no
breach. And this ignores any use value or salvage value of the new bagging system, which is the
property of Lake River — though admittedly it also ignores the time value of money; Lake River
paid $89,000 for that system before receiving any revenue from the contract.
To complete the picture, assume that the breach had not occurred till performance was 90
percent complete. Then the "liquidated damages" clause would not be so one-sided, but it would
be one-sided. Carborundum would have paid $480,000 for bagging. Against this, Lake River
would have incurred its fixed cost of $89,000 plus 90 percent of its variable costs of $337,000, or
$303,000. Its total costs would thus be $392,000, and its net profit $88,000. But on top of this it
would be entitled to "liquidated damages" of $53,000, for a total profit of $141,000 — more than
30 percent more than its expected profit of $107,000 if there was no breach.
30
Web Notes – Sixth Edition
Cooter & Ulen
The reason for these results is that most of the costs to Lake River of performing the contract
are saved if the contract is broken, and this saving is not reflected in the damage formula. As a
result, at whatever point in the life of the contract a breach occurs, the damage formula gives
Lake River more than its lost profits from the breach — dramatically more if the breach occurs at
the beginning of the contract; tapering off at the end, it is true. Still, over the interval between the
beginning of Lake River's performance and nearly the end, the clause could be expected to
generate profits ranging from 400 percent of the expected contract profits to 130 percent of those
profits. And this is on the assumption that the bagging system has no value apart from the
contract. If it were worth only $20,000 to Lake River, the range would be 434 percent to 150
percent.
Lake River argues that it would never get as much as the formula suggests, because it would
be required to mitigate its damages. This is a dubious argument on several grounds. First,
mitigation of damages is a doctrine of the law of court-assessed damages, while the point of a
liquidated-damages clause is to substitute party assessment; and that point is blunted, and the
certainty that liquidated-damages clauses are designed to give the process of assessing damages
impaired, if a defendant can force the plaintiff to take less than the damages specified in the
clause, on the ground that the plaintiff could have avoided some of them. It would seem therefore
that the clause in this case should be read to eliminate any duty of mitigation, that what Lake
River is doing is attempting to rewrite the clause to make it more reasonable, and that since
actually the clause is designed to give Lake River the full damages it would incur from breach
(and more) even if it made no effort to find a substitute use for the equipment that it bought to
perform the contract, this is just one more piece of evidence that it is a penalty clause rather than
a liquidated-damages clause. See Northwest Collectors, Inc. v. Enders, 74 Wash.2d 585, 594,
446 P.2d 200, 206 (1968).
But in any event mitigation would not mitigate the penal character of this clause. If
Carborundum did not ship the guaranteed minimum quantity, the reason was likely to be — the
reason was — that the steel industry had fallen on hard times and the demand for Ferro Carbo
was therefore down. In these circumstances Lake River would have little prospect of finding a
substitute contract that would yield it significant profits to set off against the full contract price,
which is the method by which it proposes to take account of mitigation. At argument Lake River
suggested that it 1292*1292 might at least have been able to sell the new bagging equipment to
someone for something, and the figure $40,000 was proposed. If the breach occurred on the first
day when performance under the contract was due and Lake River promptly sold the bagging
equipment for $40,000, its liquidated damages would fall to $493,000. But by the same token its
costs would fall to $49,000. Its profit would still be $444,000, which as we said was more than
400 percent of its expected profit on the contract. The penal component would be unaffected.
With the penalty clause in this case compare the liquidated-damages clause in Arduini v.
Board of Education, supra, which is representative of such clauses upheld in Illinois. The
plaintiff was a public school teacher whose contract provided that if he resigned before the end
of the school year he would be docked 4 percent of his salary. This was a modest fraction of the
contract price. And the cost to the school of an untimely resignation would be difficult to
measure. Since that cost would be greater the more senior and experienced the teacher was, the
fact that the liquidated damages would be greater the higher the teacher's salary did not make the
clause arbitrary. Even the fact that the liquidated damages were the same whether the teacher
resigned at the beginning, the middle, or the end of the school year was not arbitrary, for it was
unclear how the amount of actual damages would vary with the time of resignation. Although
31
Web Notes – Sixth Edition
Cooter & Ulen
one might think that the earlier the teacher resigned the greater the damage to the school would
be, the school might find it easier to hire a replacement for the whole year or a great part of it
than to bring in a replacement at the last minute to grade the exams left behind by the resigning
teacher. Here, in contrast, it is apparent from the face of the contract that the damages provided
for by the "liquidated damages" clause are grossly disproportionate to any probable loss and
penalize some breaches much more heavily than others regardless of relative cost.
We do not mean by this discussion to cast a cloud of doubt over the "take or pay" clauses that
are a common feature of contracts between natural gas pipeline companies and their customers.
Such clauses require the customer, in consideration of the pipeline's extending its line to his
premises, to take a certain amount of gas at a specified price — and if he fails to take it to pay
the full price anyway. The resemblance to the minimum-guarantee clause in the present case is
obvious, but perhaps quite superficial. Neither party has mentioned take-or-pay clauses, and we
can find no case where such a clause was even challenged as a penalty clause — though in one
case it was argued that such a clause made the damages unreasonably low. See National Fuel
Gas Distribution Corp. v. Pennsylvania Public Utility Comm'n, 76 Pa.Commw. 102, 126-27 n. 8,
464 A.2d 546, 558 n. 8 (1983). If, as appears not to be the case here but would often be the case
in supplying natural gas, a supplier's fixed costs were a very large fraction of his total costs, a
take-or-pay clause might well be a reasonable liquidation of damages. In the limit, if all the
supplier's costs were incurred before he began supplying the customer, the contract revenues
would be an excellent measure of the damages from breach. But in this case, the supplier (Lake
River, viewed as a supplier of bagging services to Carborundum) incurred only a fraction of its
costs before performance began, and the interruption of performance generated a considerable
cost saving that is not reflected in the damage formula.
The fact that the damage formula is invalid does not deprive Lake River of a remedy. The
parties did not contract explicitly with reference to the measure of damages if the agreed-on
damage formula was invalidated, but all this means is that the victim of the breach is entitled to
his common law damages. See, e.g., Restatement, Second, Contracts § 356, comment a (1981).
In this case that would be the unpaid contract price of $241,000 minus the costs that Lake River
saved by not having to complete the contract (the variable costs on the other 45 percent of the
Ferro Carbo 1293*1293 that it never had to bag). The case must be remanded to the district judge
to fix these damages.
Two damage issues remain. The first concerns Carborundum's expenses of delivering bagged
Ferro Carbo to its customers to replace that impounded by Lake River. The district judge gave
Carborundum the full market value of the bagged Ferro Carbo. Lake River argues that it should
not have to pay for Carborundum's expense of selling additional Ferro Carbo — additional in the
sense that Carborundum is being given credit for the full retail value of the product that Lake
River withheld. To explain, suppose that Carborundum had an order for $1,000 worth of bagged
Ferro Carbo, which Lake River was supposed to deliver; and because it refused, Carborundum
incurred a transportation cost of $100 to make a substitute shipment of bagged Ferro Carbo to the
customer. Carborundum would still get $1,000 from the customer, and if that price covered the
transportation cost it would still make a profit. In what sense, therefore, is that cost a separate
item of damage, of loss? On all Ferro Carbo (related to this case) sold by Carborundum in the
Midwest, Carborundum received the full market price, either from its customers in the case of
Ferro Carbo actually delivered to them, or from Lake River in the case of the Ferro Carbo that
Lake River refused to deliver. Having received a price designed to cover all expenses of sale, a
seller cannot also get an additional damage award for any of those expenses.
32
Web Notes – Sixth Edition
Cooter & Ulen
If, however, the additional Ferro Carbo that Carborundum delivered to its midwestern
customers in substitution for Ferro Carbo previously delivered to, and impounded by, Lake River
would have been sold in the East at the same price but lower cost, Carborundum would have had
an additional loss, in the form of reduced profits, for which it could recover additional damages.
But it made no effort to prove such a loss. Maybe it had no unsatisfied eastern customers, and
expanded rather than shifted output to fulfill its midwestern customers' demand. The damages on
the counter-claim must be refigured also.
Finally, Lake River argues that Carborundum failed to mitigate its damages by accepting
Lake River's offer to deliver the bagged product and place the proceeds in escrow. But a
converter is not entitled to retain the proceeds of the conversion even temporarily. Lake River
had an opportunity to limit its exposure by selling the bagged product on Carborundum's account
and deducting what it claimed was due it on its "lien." Its failure to follow this course reinforces
our conclusion that the assertion of the lien was a naked attempt to hold Carborundum hostage to
Lake River's view — an erroneous view, as it has turned out — of the enforceability of the
damage formula in the contract.
The judgment of the district court is affirmed in part and reversed in part, and the case is
returned to that court to redetermine both parties' damages in accordance with the principles in
this opinion. The parties may present additional evidence on remand, and shall bear their own
costs in this court. Circuit Rule 18 shall not apply on remand.
AFFIRMED IN PART, REVERSED IN PART, AND REMANDED.
Web Note 9.4 (p. 328)
Does a focus on efficient breach slight the moral basis of promising? In this web note we
consider some recent experimental and theoretical articles on the morality of completing
one’s promises.
One of the most natural intuitions regarding contract is the intuition that there is something
wrong, something morally blameworthy about failing to perform a promise to do something. All
of us feel a twinge of guilt or conscience when we fail to do something that we promised to do
(such as locking the door before going to bed) or do something that we promised not to do (like
smoking another cigarette). But contract is different from the act of promising, as we try to
indicate in Chapter 8 and as generations of law professors have tried to teach their first-year law
students. (Contra see Charles Fried, Contract as Promise (1982), and Seana Shiffrin, “The
Divergence of Contract and Promise,” 120 Harv. L. Rev. 708 (2007).)
The articles summarized below explore, first, the psychological aspects of contract breach
and, second, attempts by some distinguished law-and-economics scholars to reconcile moral and
economic attitudes toward breach.
Tess Wilkinson-Ryan & Jonathan Baron, “Moral Judgment and Moral Heuristics in Breach of
Contract,” 6 J. Emp. Legal Stud. 405 (2009).
Abstract: “Most people think that breaking a promise is immoral, and that a breach of contract is
a kind of broken promise. However, the law does not explicitly recognize the moral context of
breach of contract. Using a series of web-based questionnaires, we asked subjects to read breach
of contract cases and answer questions about the legal, financial, and moral implications of each
33
Web Notes – Sixth Edition
Cooter & Ulen
case. Our results suggest that people are quite sensitive to the moral dimensions of a breach of
contract, especially the perceived intentions of the breacher. In the first study, we framed the
motivation for a contractor’s breach as either the chance to make more money or the chance to
avoid losing money. Subjects were more punitive when the motivation appeared to be greed
(breach to gain) than when the motivation appeared to be fear (breach to avoid loss). In the
second study, we manipulated the timing of the negotiation over damages, comparing cases in
which the promisor asks to negotiate damages before definitively breaching (as in a liquidated
damages clause) with cases in which the breach has already occurred. We predicted that once
the contract is breached, the moral violation becomes very salient, and we found that subjects
were less punitive when they set damages ex ante. Finally, results from the third study suggest
that subjects seemed to believe that intentionally breaking a contractual promise is a punishable
moral harm in itself. When presented with identical losses, one from an intentional breach of
contract and the other from a negligent tort, subjects were more punitive toward the breacher
than the negligent tortfeasor. They treated willful breach as an intentional harm.”
“The sanctity of a promise is an unusually resonant moral principle. Cultural psychologists
have identified the rule of contract as one of only three universal moral norms. [Cite to Paul
Robinson, Richard Kurzban & Owen Jones, “The Origins of Shared Intuitions of Justice,” 16
Vand. L. Rev. 1633 (2007).] In economics experiments, subjects who are otherwise willing to
lie about their intentions in a cooperation game can be trusted to keep their word if they have
explicitly promised, even without threat of sanctions. [Cite to Robyn Dawes, Jeanne McTavish
& Harriet Shaklee, “Behavior, Communication, and Assumptions about Other People’s Behavior
in a Common Dilemma Situation,” 35 J. Personality & Soc. Psych. 1 (1977).]” 409.
“Stewart Macaulay reported in 1963 that many, if not most, businessmen actually had a
preference for relying on ’common honesty and decency’ or industry and social norms rather
formal contracts. [Cite to Macaulay at 55.]” 410.
“Dennis Stolle and Andrew Slain studied the effects of exculpatory clauses in contracts on
consumer behavior. They found that exculpatory language in a standard from contract had a
deterrent effect on subjects’ likelihood to seek compensation, even when it is not clear that the
exculpatory clause would be legally enforceable.” [Cite to Dennis P. Stolle & Andrew J. Slain,
“Standard Form Contracts and Contract Schemas: A Preliminary Investigation of the Effects of
Exculpatory Clauses on Consumers’ Propensity to Sue,” 15 Beh. Sciences and the Law 83
(1997).] 410.
“To the extent that subjects find breach of contract to be morally wrong, prior research
suggests that they will focus on the punishment that the breacher ‘deserves’ rather than the rules
that would create the most efficient incentives.” 411.
“In the criminal context, John Darley and Paul Robinson have repeatedly shown that subjects
are more sensitive to morally salient information than they are to factors associated with
deterrence rationales, and that people punish in line with retributive theories of justice.” [Cite to
Paul Robinson & John Darley, “The Utility of Desert,” 91 Nw. U. L. Rev. 453 (1997) and Kevin
Carlsmith, John Darley & Paul Robinson, “Why Do We Punish: Deterrence and Just Deserts as
Motives for Punishment,” 83 J. Personality & Soc. Psych. 284 (2002).] 412.
The experiments involved a “panel recruited over a 10-year period. Approximately 90
percent of respondents were U.S. residents (with the rest mostly from Canada). The panel is
roughly representative of the adult U.S. population in terms of income, age, and education but
not in terms of sex, because (for unknown reasons) women predominate in our respondent pool.”
412.
34
Web Notes – Sixth Edition
Cooter & Ulen
In the first experiment, the authors “predicted that subjects would be more sympathetic to a
breacher who breaks a contract in order to avoid a loss than an otherwise identical breacher who
breaks a contract in order to accept a more lucrative deal elsewhere.” 10. They did a betweensubjects manipulation. K for kitchen renovation. In Avoid Loss condition, prices of inputs had
risen quickly and unexpectedly so that the K price would not cover the cost of materials. In the
Gain condition, contractor learns that a shortage of skilled workers in a nearby area has caused
prices for similar work to rise. He breaks the contract to go to that other area to make more
money. 413-14.
“Subjects who saw the breach to gain scenario set the damages at a mean level of 4.08, while
subjects who saw the breach to avoid loss scenario set the level of damages at 3.14, where 3 was
the expectation level.” Differences were statistically significant.
Saw same effect in a within-subjects design. 414.
In experiment 2 they manipulated timing. “We hypothesized that subjects would set lower
damages if they were negotiating the cost of a possible future breach rather than assigning blame
once the contract is irreparably broken.” 415.
Scenario is a party rental. Bakers rent a local restaurant for an anniversary party. Owner of
restaurant is offered much more for same night. In one version there is a liquidated damages
clause. In another, the owner calls to ask how much they would take to release him from the
contract. In yet another version, the breach is a foregone conclusion and there is no negotiation.
“Subjects assigned lower damages when the amount was negotiated rather than decided after the
breach.” Describe three conditions as “a liquidated-damages clause in the contract; a request to
be released from the contract; and a simple breach. The mean scale values for compensation
(where expectation damages are 3) were, respectively, 4.51, 4.53, and 4.88.” 415-7.
In experiment three, “we want to ask what, exactly, is the moral content of a contract. Our
hypothesis is that subjects consider breaking a promise to be a harm in itself, and that they will
punish an intentional harm more severely than a negligent harm.” They set up scenarios that
compared “breaking a contract with causing an identical loss negligently.” 15. Someone breaks
a contract to take a more lucrative offer versus someone breaks a contract because “a third party
negligently causes a harm that in turn prevents performance.” 417-20.
Contract to redo floors prior to selling a condo. Breaks the contract to do a more rewarding
job in one scenario. Breaks the contract because a neighbor tries to do some repair work to his
apartment and releases toxic substance that makes it impossible to do the refinishing job. 417.
“Subjects thought that a person who caused harm via breaking a contractual promise was
more immoral and should feel more guilt than a person who caused harm via negligence.” 418.
“People’s moral intuitions about contract law may make breach less frequent than is
economically efficient, and may inhibit the parties’ ability to settle out of court if there is a
breach.” 423.
Tess Wilkinson-Ryan & David A. Hoffman, “Breach Is for Suckers,” 63 Vand. L. Rev. 1003
(2010).
Abstract: “This paper presents results from three experiments offering evidence that parties
see breach of contract as a form of exploitation, making disappointed promisees into ‘suckers.’
In psychology, being a sucker turns on a three-part definition: betrayal, inequity, and intention.
We used web-based questionnaires to test the effect of each of the three factors separately. Our
results support the hypothesis that when breach of contract cues an exploitation schema, people
become angry, offended, and inclined to retaliate even when retaliation is costly. This theory
35
Web Notes – Sixth Edition
Cooter & Ulen
offers a useful advance insofar as it explains why victims of breach demand more than similarly
situated tort victims and why breaches to engorge gain are perceived to be more immoral than
breaches to avoid loss. In general, the sucker theory provides an explanatory framework for
recent experimental work showing that individuals view breach as a moral harm. We describe
the implications of this theory for doctrinal problems like liquidated damages, willful breach, and
promissory estoppel, and we suggest an agenda for future research.”
“We propose that people think of breach of contract as a form of exploitation, a violation of
the norm of reciprocity. … Psychological research has shown that people are unusually
sensitive to the suspicion that they are being exploited.”
“We offer evidence that individuals perceive a relational harm even when the contract itself
is a simple, one-shot commercial arrangement. Even when the complex interpersonal dynamics
of relational contracts are stripped away, moral and social norms like reciprocity still matter.”
“In one experiment from that series of studies, subjects were asked to choose the appropriate
level of damages themselves, and then to indicate whether breach was morally problematic if the
promisor paid the specified damages. On average, subjects asked for damages 2.19 times the
expectation value. And, further, on a scale of 1 to 7, where 1 was ‘not immoral,’ 4 was
‘somewhat immoral,’ and 7 was ‘extremely immoral,’ participants thought that breach rated over
5—even though in many cases subjects had chosen supracompensatory awards.”
“People do not seem to be troubled by the prospect of assigning a dollar value to a loss in
tort. But something is different in contract, and we propose here that the difference is in the
relationship of the parties to one another.”
“When parties sign a contract, they form a special relationship with one another.
Psychologically speaking, this relationship involves expectations of trust and reciprocity.”
“Psychological evidence suggests that people will be offended at the idea that money will
remediate the perceived betrayal inherent in breach, which is ultimately a relational rather than
an economic harm.”
There are “three essential elements to feeling suckered”—betrayal, inequity, and intention.
“In one Ultimatum game experiment [], subjects were assigned to one of two possible
ultimatum games. In one, they were told that the offer from the Proposer was generated
randomly by a computer; in the other, the Proposer could choose what to offer. When subjects
that the computer was generating the offers randomly, they indicated that they would accept any
distribution. When they believed the offers were chosen intentionally, participants were more
likely to reject at least some positive offers.” Citing Sally Blount, When Social Outcomes Aren’t
Fair: The Effect of Causal Attributions on Preferences, 63 ORG. BEH. & HUM. DEC. PROCESSES
131 (1995).
“When people feel suckered, they want to impose punishment, even if that punishment is
costly and pointless. … Classic economic studies of a phenomenon termed ‘altruistic
punishment’ have shown that players in a public goods game will punish free riders, even when
the punishment costs the punisher money and has no effect on the punisher’s future dealings with
the free-rider. In other words, people will sacrifice some economic efficiency for revenge.”
Citing Ernst Fehr & Simon Gachter, Altruistic Punishment in Humans, 415 NATURE 137 (2002).
“Several people die each year ‘as a result of hostile physical encounters with vending
machines.’” Citing Kathleen Vohs, Roy Baumeister & Jason Chin, Feeling Duped: Emotional,
Motivational, and Cognitive Aspects of Being Exploited by Others, 11 REV. GEN. PSYCH. 127
(2007).
36
Web Notes – Sixth Edition
Cooter & Ulen
“If people experience breach as exploitation, it could have serious consequences for
subsequent contracts—they may prefer not to enter into contracts at all, and when they do make
contracts, they may take costly precautions to protect themselves against breach.”
“Equally worrisome is the prospect of people taking costly precautionary measures.”
Symposium: “Fault in American Contract Law,” 107 Mich. L. Rev. (2009).
Articles by Richard A. Posner, “Let Us Never Blame a Contract Breaker”; Saul Levmore,
“Stipulated Damages, Super-Strict Liability, and Mitigation in Contract Law”; Robert E. Scott,
“In (Partial) Defense of Strict Liability in Contract”: Ariel Porat, “A Comparative Fault Defense
in Contract Law”; Melvin Aron Eisenberg, Eric A. Posner; George M. Cohen; Richard A.
Epstein; Oren Bar-Gill & Omri Ben-Shahar; Richard Craswell; Steve Thel & Peter Siegelman;
Roy Kreitner; Seana Shiffrin; Steve Shavell; and Stefan Grundman.
Richard A. Posner, “Let Us Never Blame a Contract Breaker,” 107 Mich. L. Rev. 1349 (2009).
Holmes’s famous “no fault” theory of breach of contract. In HOLMES, THE COMMON LAW
107-10, 299-301 (1881) and Holmes, “The Path of the Law, 10 Harv. L. Rev. 457, 462 (1897).
“Holmes’s theory of contract law is as fault free as his theory of tort law is fault saturated.
He thought of contracts as options—when you sign a contract in which you promise a specified
performance (supplying a product, or providing a service), you by an option to perform or pay
damages.” 1350. “Path of the Law,” 462.
“In contrast, a general entitlement to specific performance would indeed make contract law
fault based.” 1350.
“The option theory of contract also implies that liability for the breach of a contract is strict,
that is, that the victim of the breach need not prove fault by the contract breaker (another reason
why specific performance can’t be the standard remedy for breach).” 1351.
“The difference between the common law and civil law conceptions of contract law may be
due to the fact that the common law of contracts evolved from the law merchant and the civil law
of contracts from canon law.” 1352. Citing Joseph M. Perillo, “Essay: UNIDROIT Principles of
International Commercial Contracts: The Black Letter Text and a Review,” 63 Fordham L. Rev.
281 (1994).
“We generally want people to be honest and aboveboard in their dealings with others. But
there is no general duty of good faith in contract law. If you offer a low price for some good to
its owner, you are not obliged to tell him that you think the good is underpriced—that he does
not realize its market value and you do. You are not required to be an altruist, to be candid, to be
a good guy. You are permitted to profit from asymmetry of information. If you could not do
that, the incentive to discover information about true values would be blunted. It is an example
of the traditional economic paradox that private vice can be public virtue.” 1357-58.
“There is a legally enforceable contract duty of ‘good faith,’ but it is just a duty to avoid
exploiting the temporary monopoly position that a contracting party will sometimes obtain
during the course of performance.” 1358.
“Another example, this one involving the buyer’s conduct rather than the seller’s, is the rule
that reads a ‘best efforts’ obligation on the part of a dealer into the dealership contract if his
supplier has given him an exclusive right to sell the supplier’s product. Exclusivity gives the
dealer a monopoly during the life of the contract, and the best efforts obligation prevents him
from exploiting it. (The benefit of the monopoly to the supplier is that it gives the dealer an
incentive to promote the supplier’s product; the dealer doesn’t have to worry about free riding by
37
Web Notes – Sixth Edition
Cooter & Ulen
competing dealers in that product.) Nothing is gained by describing the dealer who in the
absence of a best-efforts duty would exploit the monopoly conferred by the exclusive contract as
‘blameworthy.’” 1359.
Steven Shavell, “Why Breach of Contract May Not Be Immoral Given the Incompleteness of
Contracts,” 107 Mich. L. Rev. 1569 (2009).
Abstract: “There is a widely held view that breach of contract is immoral. I suggest here
that breach may often be seen as moral, once one appreciates that contracts are incompletely
detailed agreements and that breach may be committed in problematic contingencies that were
not explicitly addressed by the governing contract. In other words, it is a mistake generally to
treat a breach as a violation of a promise that was intended to cover the particular contingency
that eventuated.” 1569.
Steven Shavell, “Is Breach of Contract Immoral?,” 56 Emory L.J. 439 (2006).
Abstract: “The view that there is something wrong with a person’s breaching a contract is
widely held. I argue here that this view is misleading—essentially because the particular
contingency that led to a breach will often not have been explicitly addressed in a contract. If so,
we will not know if the breach should be considered immoral, for we will not know whether the
parties would have required performance had they addressed the contingency that arose.
However, we can make an important inference if expectation damages must be paid for a breach:
The breach probably was not immoral, since the breaching party’s willingness to pay expectation
damages suggests that performance would not have been required in a contract providing
explicitly for the contingency that occurred. This conclusion is related to breach and damages in
practice, to a survey that I conducted about the morality of breach, and to the opinions of
commentators on the morality of breach and on the ‘efficiency’ of breach.”
Web Note 9.5 (p. 347)
The opinion in the fishing-crew case described above is available on our website with
some additional questions.
Following is Alaska v. Domenico case opinion with some additional notes and a question.
Alaska Packers' Association v. Domenico
17F. 99 (9th Cir. 1902)
ROSS, Circuit Judge. The libel in this case was based upon a contract alleged to have been
entered into between the libelants and the appellant corporation on the 22d day of May, 1900, at
Pyramid Harbor, Alaska, by which it is claimed the appellant promised to pay each of the libelants,
among other things, the sum of $100 for services rendered and to be rendered. In its answer the
respondent denied the execution, on its part, of the contract sued upon, averred that it was without
consideration, and for a third defense alleged that the work performed by the libelants for it was
performed under other and different contracts than that sued on, and that, prior to the filing of the
libel, each of the libelants was paid by the respondent the full amount due him thereunder, in
consideration of which each of them executed a full release of all his claims and demands against
the respondent.
38
Web Notes – Sixth Edition
Cooter & Ulen
The evidence shows without conflict that on March 26, 1900, at the city and county of San
Francisco, the libelants entered into a written contract with the appellant, whereby they agreed to go
from San Francisco to Pyramid Harbor, Alaska, and return, on board such vessel as might be
designated by the appellant, and to work for the appellant during the fishing season of 1900, at
Pyramid Harbor, as sailors and fishermen, agreeing to do “regular ship's duty, both up and down,
discharging and loading; and to do any other work whatsoever when requested to do so by the
captain or agent of the Alaska Packers’ Association.” By the terms of this agreement, the appellant
was to pay each of the libelants $50 for the season, and two cents for each red salmon in the
catching of which he took part.
On the 5th day of April, 1900, 21 of the libelants signed shipping articles by which they shipped
as seamen on the Two Brothers, a vessel chartered by the appellant for the voyage between San
Francisco and Pyramid Harbor, and also bound themselves to perform the same work for the
appellant provided for by the previous contract of March 26th; the appellant agreeing to pay them
therefor the sum of $60 for the season, and two cents each for each red salmon in the catching of
which they should respectively take part. Under these contracts, the libelants sailed on board the
Two Brothers for Pyramid Harbor, where the appellant had about $150,000 invested in a salmon
cannery. The libelants arrived there early in April of the year mentioned, and began to unload the
vessel and fit up the cannery. A few days thereafter, to wit, May 19th, they stopped work in a body,
and demanded of the company's superintendent there in charge $100 for services in operating the
vessel to and from Pyramid Harbor, instead of the sums stipulated for in and by the contracts;
stating that unless they were paid this additional wage they would stop work entirely, and return to
San Francisco. The evidence showed, and the court below found, that it was impossible for the
appellant to get other men to take the places of the libelants, the place being remote, the season short
and just opening; so that, after endeavoring for several days without success to induce the libelants
to proceed with their work in accordance with their contracts, the company's superintendent, on the
22d day of May, so far yielded to their demands as to instruct his clerk to copy the contracts
executed in San Francisco, including the words “Alaska Packers’ Association” at the end,
substituting, for the $50 and $60 payments, respectively, of those contracts, the sum of $100, which
document, so prepared, was signed by the libelants before a shipping commissioner whom they had
requested to be brought from Northeast Point; the superintendent, however, testifying that he at the
time told the libelants that he was without authority to enter into any such contract, or to in any way
alter the contracts made between them and the company in San Francisco. Upon the return of the
libelants to San Francisco at the close of the fishing season, they demanded pay in accordance with
the terms of the alleged contract of May 22d, when the company denied its validity, and refused to
pay other than as provided for by the contracts of March 26th and April 5th, respectively. Some of
the libelants, at least, consulted counsel, and, after receiving his advice, those of them who had
signed the shipping articles before the shipping commissioner at San Francisco went before that
officer, and received the amount due them thereunder, executing in consideration thereof a release
in full, and the others being paid at the office of the company, also receipting in full for their
demands.
On the trial in the court below, the libelants undertook to show that the fishing nets provided by
the respondent were defective, and that it was on that account that they demanded increased wages.
On that point, the evidence was substantially conflicting, and the finding of the court was against the
libelants, the court saying:
The contention of libelants that the nets provided them were rotten and unserviceable is not sustained
by the evidence. The defendant's interest required that libelants should be provided with every
39
Web Notes – Sixth Edition
Cooter & Ulen
facility necessary to their success as fishermen, for on such success depended the profits defendant
would be able to realize that season from its packing plant, and the large capital invested therein. In
view of this self-evident fact, it is highly improbable that the defendant gave libelants rotten and
unserviceable nets with which to fish. It follows from this finding that libelants were not justified in
refusing performance of their original contract.
The evidence being sharply conflicting in respect to these facts, the conclusions of the court,
who heard and saw the witnesses, will not be disturbed. …
The real questions in the case as brought here are questions of law, and, in the view that we take
of the case, it will be necessary to consider but one of those. Assuming that the appellant's
superintendent at Pyramid Harbor was authorized to make the alleged contract of May 22d, and that
he executed it on behalf of the appellant, was it supported by a sufficient consideration? From the
foregoing statement of the case, it will have been seen that the libelants agreed in writing, for certain
stated compensation, to render their services to the appellant in remote waters where the season for
conducting fishing operations is extremely short, and in which enterprise the appellant had a large
amount of money invested; and, after having entered upon the discharge of their contract, and at a
time when it was impossible for the appellant to secure other men in their places, the libelants,
without any valid cause, absolutely refused to continue the services they were under contract to
perform unless the appellant would consent to pay them more money. Consent to such a demand,
under such circumstances, if given, was, in our opinion, without consideration, for the reason that it
was based solely upon the libelants' agreement to render the exact services, and none other, that they
were already under contract to render. The case shows that they willfully and arbitrarily broke that
obligation. ...
Certainly, it cannot be justly held, upon the record in this case, that there was any voluntary
waiver on the part of the appellant of the breach of the original contract. The company itself knew
nothing of such breach until the expedition returned to San Francisco, and the testimony is
uncontradicted that its superintendent at Pyramid Harbor, who, it is claimed, made on its behalf the
contract sued on, distinctly informed the libelants that he had no power to alter the original or to
make a new contract; and it would, of course, follow that, if he had no power to change the original,
he would have no authority to waive any rights thereunder. ...
It results from the views above expressed that the judgment must be reversed, and the cause
remanded, with directions to the court below to enter judgment for the respondent, with costs. It is
so ordered.
Notes: A civil action today begins with the plaintiffs filing a complaint. In admiralty law actions
were begun by the filing of a “libel;” and the person or persons seeking relief were called
“libelants.” Since 1966 the Federal Rules of Civil Procedure and Supp. Admiralty Rules have
governed admiralty actions so that they are now, like civil actions, commenced by complaint.
Question: Another court, approving the result in the principal case, has characterized the conduct
of the libellants as “an attempt to exploit the contract promisee’s lack of an adequate legal remedy.”
Selmer Co. v. Blakeslee-Midwest Co., 704 F.2d 924, 927 (7th Cir. 1983). If that is an accurate
characterization, does it strengthen or weaken the argument for putting the decision in Alaska on the
ground of duress, not consideration?
Web Note 9.6 (p. 370)
40
Web Notes – Sixth Edition
Cooter & Ulen
There is much more to be said about the troubling and troubled subject of
unconscionability. We discuss some additional literature and cases involving that
doctrine and pose additional questions about them on our website.
The position that we try to articulate in the text is that unconscionability is best understood as
a problem of situational monopoly – that is, not the run-of-the-mill monopoly that economics
defines but, rather, an instance in which unanticipated circumstances confer a monopoly position
on someone and that person takes advantage of that monopolistic position. (It would be, of
course, a different matter – one more amenable to conventional economic analysis – if the
monopolist had set out to create the situation that conferred the monopoly position upon him or
her.)
Related to this notion is one that we have not entirely worked through but we think is
promising – taking advantage of someone through knowledge of behavioral imperfections of
which the other decision-maker is unaware. To illustrate, suppose that a seller understands that
people generally have difficulty dealing with probabilistic events. They do not, for example,
understand that the joint probability of two independent events is equal to the product of their
(marginal) probabilities. So, the probability of throwing two sixes with two dice is equal to 1/6 x
1/6 = 1/36. Suppose that a seller offers a buyer an insurance contract that, in order to pay for an
insurable loss, requires the occurrence of two independent, probabilistic events. The buyer may
not realize how unlikely this joint probability is; he may, instead, believe the two events to be
likely to occur together. He may, therefore, pay more for the insurance coverage than he ought
to.
There are lots of details of this connection between behavioral imperfections and advantagetaking to be worked out, but there may be some promise in that connection for understanding
some additional aspects of unconscionability.
The best place to begin a study of unconscionability is in Melvin A. Eisenberg’s “The
Bargain Principle and Its Limits,” 95 Harv. L. Rev. 741 (1982), to which we refer in the text.
The second half of Eisenberg’s classic article outlines some fascinating examples of (possibly)
unconscionable behavior.
We also recommend Chapter 6 from Fuller & Eisenberg, Basic Principles of Contract Law,
“The
Principle
of
Unconscionability”
(available
on-line
at
http://escholarship.org/uc/item/77h162nt#page-3); Eisenberg, “The Role of Fault in Contract
Law: Unconscionability, Unexpected Circumstances, Interpretation, Mistake, and
Nonperformance,” 104 Mich. L. Rev. 82(2006); Lucien Bebchuk & Richard A. Posner, “OneSided Contracts in Competitive Consumer Markets,” 104 Mich. L. Rev. 827 (2006); Russell B.
Korobkin, “A ‘Traditional’ and ‘Behavioral’ Law-and-Economics Analysis of Williams v.
Walker-Thomas Furniture Co.,” 26 U. Hawaii L. Rev. 441 (2004); Larry A. DiMatteo & Bruce
Louis Rich, “A Consent Theory of Unconscionability: An Empirical Study of Law in Action,” 33
Fla. St. U. L. Rev. 1067 (2006).
Web Note 9.7 (p. 370)
There is an increasing amount of interesting empirical work on contract law. We discuss
that literature—especially that on unfair contract terms in new car deals by Professor Ian
Ayres of Yale and a summary of that literature by Professor Russell Korobkin of
UCLA—on our website.
41
Web Notes – Sixth Edition
Cooter & Ulen
The articles that we discussed in the text (such as those by Adam Badawi, Tess WilkinsonRyan, and Florencia Marotta-Wurgler) are some of the most fascinating of a rich crop of new
articles looking at empirical aspects of contract. The articles that we summarize below are also
fascinating. We begin with a marvelous overview by Russell Korobkin and then proceed to a
famous and influential empirical study of one aspect of contracting by Ian Ayres.
We urge you to consult each new issue of the Journal of Empirical Legal Studies (see
http://onlinelibrary.wiley.com/doi/10.1111/jels.2010.7.issue-4/issuetoc) in order to see cuttingedge empirical scholarship on contracts.
Before we get to the summaries, let us note how much we do not know about contracts in the
United States and, for that matter, in almost any other jurisdiction. For example, we do not know
how many contracts are entered into in a given time period, how many of those are individual-toindividual agreements, how many are individual-to-commercial entity agreements, how many of
them are successfully and completely performed, how many are renegotiated, how many are
abandoned, how many are contested, and so on. Once one starts asking these empirical
questions, one realizes how very little we know.
Russell Korobkin, “Empirical Scholarship in Contract Law: Possibilities and Pitfalls,” 2002 U
Ill. L. Rev. 1033.
In this article, Professor Korobkin analyzes empirical contract law scholarship over the last
fifteen years in order to provide scholars with a menu of the empirical approaches available to
them, and also in order to help scholars determine whether their research efforts would be used
most productively in the pursuit of empirical analysis. Also, he categorizes empirical contract
law scholarship by both the source of data and main purpose of the investigation. In addition,
professor Korobkin describes and analyzes a series of conceptual problems with using
empiricism in contract law scholarship.
Professor Korobkin describes that the body of recent research published in law journal is
surprisingly small which presents a sizeable opportunity for scholars to help to define the
emerging field. He also offers the range of different data sources available to empirical contract
law scholars and the variety of ways data can be used in scholarship concerning contract
doctrine. In addition, professor Korobkin argue that can be made three kinds of criticisms of
empirical scholarship: first, the findings might not be generalizable; second, the data presented
fails to adequately support the article’s thesis; and third, the data itself is inconclusive. Moreover,
he argues that there are ways scholars can minimize these pitfalls to maximize the usefulness of
their work. Finally, professor Korobkin suggests that the area of study of “effect of mandatory
contract rules on private contracting behavior” is likely to benefit from empirical research, but is
rarely investigated empirically.
Ian Ayres, “Further Evidence of Discrimination in New Car Negotiations and Estimates of its
Cause,” 94 Mich. L. Rev. 109 (1995).
The original discrimination study was published in 1991, and showed that test of new car
dealership in Chicago indicated that dealerships offered significantly lower prices to white male
testers that to a similarly situated black and-or female testers: white female testers were asked to
pay 40 percent higher markups than white male testers; and black female testers were asked to
pay more than three times the markup of white male testers. In this article, professor Ayres
extends the results of this initial test by presenting not only more authoritative evidence of
42
Web Notes – Sixth Edition
Cooter & Ulen
discrimination but also a new quantitative method of identifying the causes of discrimination (by
expanded audits). This study presents more authoritative results than the original study because
there is a larger sample size and more testers in each race-gender category, and because the tests
were conducted with enhanced control to ensure further that testers were similar except for their
race and gender.
The results of the present article confirm the previous finding that dealers systematically
offer lower prices to white males than to other tester types. However, the data reveal a different
ordering of discrimination, unlike the original study, the black male testers were charged higher
prices than the black female testers.
Professor Ayres uses the game-theoretic analysis of sellers’ negotiation strategy to make
some inferences of possible causes of the sellers’ demonstrated race and gender discrimination.
He affirms that game-theoretic analysis of bargaining predicts that seller’s strategy will be a
function of the seller’s beliefs about certain variables, including the buyer’s reservation price and
the buyer’s and seller’s costs of bargaining. This article attempts at deriving numerical estimates
of these structural parameters. Also, this article presents evidence about the sellers’ initial offers,
final offers, and the lengths of the negotiation in order to estimate crudely the seller’s beliefs
about buyers’ reservation prices, the buyers’ costs of bargaining, and the sellers’ costs of
bargaining. Then, this process was repeated to estimate the seller’s beliefs about each type of
race-gender tester. The article, by the evidence of seller’s beliefs, shows four different causal
theories of discrimination. First, sellers may have higher costs per period negotiation with certain
buyer types - “associational animus.” Second, sellers may desire to disadvantage certain buyer
types - “consequential animus.” Third, certain buyer types may have higher per-period
negotiation costs - “cost-based statistical discrimination.” Fourth, certain buyer types may have
higher reservation prices - “revenue-based statistical discrimination.”
According to Professor Ayres, the bargaining game suggests three primary conclusions:
sellers discriminate against different buyer types for different reasons. Cost-based inferences
may explain part of sellers’ discrimination against black females while consequential animus
may explain part of sellers’ discrimination against black males; the sellers’ bargaining behavior
is inconsistent with associational animus but supports, especially regarding black males,
consequential animus as a partial cause of the sellers’ discrimination; the sellers’ bargaining
behavior is broadly consistent with revenue-based statistical inferences as a partial cause of the
sellers’ discrimination. In addition, he argues that these conclusions are generally consistent with
ancillary evidence about the causes of discrimination. Finally, professor Ayres considers legal
remedies and suggests that the types of discrimination uncovered in these audits could be
reduced by encouraging dealers to switch to no-haggle sales and that enhanced consumer
protection laws might be successful in nudging the market toward a no-haggle equilibrium.
What follows here is a selection of summaries of some articles on some empirical issues in
contract law, including some articles from the economic literature on contracts, a literature that
approaches the subject in a very different manner from that of law and economics.
Russell Korobkin, “The Status Quo Bias and Contract Default Rules,” 83 Cornell L.Rev. 608
(1998).
Professor Korobkin affirms that the contracting parties cannot explicitly allocate rights and
responsibilities for all possible contingencies that might arise over the life of the contract. Also,
43
Web Notes – Sixth Edition
Cooter & Ulen
preparing for all foreseeable contingencies, no matter how remote, can be both difficult and
costly. Consequently, there are gaps in the contract’s explicit and implicit provisions that leave
the parties’ obligations unspecified under certain contingencies. These contractual gaps fall to
public institutions, courts and legislatures, to create background, or “default,” rules to govern
private relationships when such unaddressed contingencies arise and private ordering has failed.
The main point of discussion in the contract-theory is the process by which lawmakers should
determine the substance of such default rule. Professor Korobkin also affirms that law-andeconomics theorists concerned with selecting efficient legal rules, and actually efficiency is the
proper goal of contracts default rule. But contracts scholars concerned with selecting efficient
default rules uniformly base their analysis upon a dubious assumption about the behavior of
contracting parties: that the contracting parties’ preferences of the substantive terms of their
contracts remain the same regardless of the choice of the default rules. He calls this assumption
the “preference exogeneity assumption.”
In this article, professor Korobkin argues that the preference exogeneity assumption is false
because when the lawmakers anoint a contract term the default, the substantive preferences of
contracting parties shift – that terms become more desirable, and other competing terms
becoming less desirable. First, he shows a series of controlled experiments designed to test the
preference exogeneity assumption in the context of contract default rule. Second, Korobkin
describes why the falsity of the preference exogeneity assumption matters, and has important
implications for efficiency theory. Also, he argues that it results in an additional source of
contractual inefficiency. Theoreticians and lawmakers concerned with creating efficient default
rules must add to and account for their analysis another source of contractual inefficiency in
addition to the usual litany: not only might parties fail to contract around inefficient default rules
because of high transaction costs or strategic incentives to withhold private information, they
might also fail to contract around inefficient defaults when their preference for maintaining the
status quo relative to alternative states swamps their preference for the alternative contract term
relative to the default term. In addition Korobkin explores the implications of this “status quo
bias” that contract default terms create and provides a theory of how lawmakers should select
contract default rules to neutralize the status quo bias. Finally, he suggests that the proper
approach to the problem is to create default rules “tailored” to the circumstances of particular
contracting parties or to impose “non-enforcement” defaults, in which courts refuse to enforce a
contract unless the parties explicitly provide for certain contingencies.
Russell Korobkin, “Inertia and Preference in Contract Negotiation: The Psychological Power of
Default Rules and Form Terms,”51 Vand. L. Rev. 1853 (1998).
In the previous article professor Korobkin argues that contracting parties are less likely to
bargain around default contract terms established by the law than the Coase theorem would
predict because the parties are likely to view default terms as a constituent part of the status quo,
much like an entitlement. If this claim is correct has not only a positive implication, but also a
normative implication for the analysis of contract default rules. The positive implication leads to
predictions that differ from traditional law and economics analysis about necessary
circumstances for contracting parties to bargain around default rules. The normative implication
suggests somewhat different strategies for lawmakers interested in selecting contract default
rules that will enable private bargainers to maximize allocative efficiency.
In this article professor Korobkin advances two primary claims in an attempt to broaden and
deepen the scope of previous analysis. First, he argues that the status quo bias has broader
44
Web Notes – Sixth Edition
Cooter & Ulen
ramifications for contract negotiations than causing parties to prefer terms identified as legal
defaults to those that are not legal defaults. He asserts that operative dichotomy for negotiators is
between inaction and action. Parties are likely to favor default terms, in many instances, because
these terms are often correlated with inaction (i.e., the default terms will be operative if the
parties do nothing). But contracting parties will tend to favor any terms that will operate in the
absence of a specific agreement to the contrary, called by the author as the “inertia theory” of
contract negotiation.
The second claim is regarding the motivational basis of negotiators’ preference for inaction
over action. Korobkin asserts that a large body of psychological literature demonstrates that
individuals suffer more regret from taking ill-fated actions than failing to act, and it is consistent
with evidence that individuals are not biased against action when the consequences of actions are
certain. Thus, he argues that a bias in favor of inaction minimizes possible future regret that a
negotiator might experience if agreed upon contractual turn out, in hindsight, to be undesirable.
Consequently, negotiators do not choose between possible contract terms solely on the basis of
the inherent expected utility of each term. Rather, inaction is weighed as a positive factor in the
negotiator’s cost-benefit analysis.
In conclusion, professor Korobkin suggests that the inertia theory of contract negotiations has
further implications, and potential study of many other points.
Alessandro Rossi, Incentives in Managerial Compensation: A Survey of Experimental Research,
Working paper (1999).
The aim of this paper is to provide a comprehensive survey of experimental contributions to
contract and incentive design issues and to offer some suggestions for future research.
Rossi shows the contribution of the experimental economics literature to analysis of issues
related to managerial incentive design. Despite the incompleteness of the survey, it should be
evident that an experimental approach may be a valuable instrument with which to test and
challenge, under controlled conditions, a wide variety of interesting theoretical issues, such as
the behavioral properties of various types of incentive scheme, and how the real behavior of
agents and principals is affected by reciprocity considerations. Also, he suggests that the first
results of experimental studies are particularly useful and interesting to incentive designers in
organizations, and they emphasize the need for further laboratory investigation. Concluding, he
gives suggestions for future experimental research.
George P. Baker and Thomas N. Hubbard, “Empirical Strategies in Contract Economics:
Information and The Boundary of the Firm,” 91 Am. Econ. Rev. – (2001).
In this paper, professor Baker and Hubbard discuss empirical strategies for examining some
of the recent theoretical work on firms’ boundaries. The discussion emphasizes the importance of
testing theories’ general propositions rather than specific models, the returns from field work in
linking conceptual and institutional detail, and the promise of empirical strategies that rely on
variation in the contracting environment. They focus on two seminal papers in this large
literature: Grossman and Hart (1986) and Holmstrom and Milgrom (1994).
Baker and Hubbard explain about two main empirical testing strategies: empiricists can
either attempt to test the theory in the specific context contemplated by the theorist or look for
other implications suggested by a more general application of the theory’s main ideas. The latter
plan requires that empiricists apply the theory to their own specific context and generate testable
propositions themselves, and then examine these propositions with data. The advantage of the
45
Web Notes – Sixth Edition
Cooter & Ulen
latter alternative is that researchers can examine general propositions in a wider range of
contexts. The disadvantage is that they have a more difficult applied theoretical task. They argue
that data availability will require applied work in contract economics to rely heavily on the
second option. Thus, while they will motivate some of the discussion through Grossman and
Hart’s and Holmstrom and Milgrom’s well-known specific models, the basic concern is with the
task of testing the authors’ general ideas in contexts not considered by them.
Steward Macaulay, “An Empirical View of Contract,” 1985 Wis. L. Rev. 465.
Professor Steward Macaulay, in this paper, attempts to reconsider what he wrote in his
famous 1963 (noted above in the note about relational contracting). Also he presents some new
notes about contract law. In addition, he considers what difference all of this makes to those
interested in contracts and law and society research, and he presents developments in the United
States.
P. A. Chiappori & B. Salanie, “Testing Contract Theory: A Survey of Some Recent Work,” in
M. Dewatripoint, L. Hansen, & S. Turnovsky, eds., Advances in Economics and Econometrics
(2002).
“Since the early seventies, the development of the theoretical literature on contracts has been
nothing short of explosive. However, until the beginning of the eights, empirical tests using
actual data and econometric methods were very rare, even though the theoretical literature had
by then given birth to a large number of interesting testable predictions. Nowadays, a number of
empirical researchers have turned their attention to the theory of contracts, but the field is not
exhaustive.
Chiappori and Salanie limited their work for situations where contracts are explicit and the
details of the contractual agreement are available to the econometrician. Also they do not cover
some areas where excellent surveys of the empirical literature have been written recently such as
on auctions, on the provision of incentives in firms, and on optimal of risk sharing within a
group.
Chiappori and Salanie, in this paper, present the effect of contractual forms on behavior. This
comprises the measure of “incentive-effect”, i.e. the increase in productivity generated by
moving to higher-powered incentive contract. Also, they consider that the decisions to participate
in a relationship or the choice of a contract in a menu of contracts all are effects of contractual
forms on behavior. Then, they talk about the optimality of observed contracts, and the main point
is whether the theory predicts well the contractual forms that we actually observe. In addition,
Chiappori and Salanie argue that the econometrics of contracts is a very promising and
burgeoning field, and has been shown to be less difficult than expected to find data that is
amenable to econometric techniques.
In conclusion, Chiappori and Salanie argue that their survey provides very strong evidence
that contractual forms have large effects on behavior. Regarding whether observed contracts take
the form predicted by the theory they found mixed evidence. Also, they emphasize the role of the
selection, matching and contract endogeneity issues. These problems are prevalent in the two
approaches they distinguish - i.e., whether one is testing for the optimally of contracts or for the
behavioral impact of given contractual forms. Finally, Chiappori and Salanie affirms that they
would like to see more econometricians inspired by their work to contribute to the growing
literature on testing of contract theory.
46