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November 14, 2008

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Tim Cullen

Let me add two other observations about how the legal acceptance of efficient breach might actually reduce social welfare. (On a personal note, this doctrine has bugged me since I learned it in my 1L contracts class--taught by a UChicago alum, no less).

First is the degradation to the value of all promises when a contract is efficiently breached. I'm sure this has been studied empirically, but I would imagine that aggregate damage that occurs because of these 'efficiently' broken is not insubstantial. At what cost is the increased uncertainty and risk associated associated with contracting in an environment where promises can be broken if the underlying economics change? Is there any work on this approach out there?

Following from that is the internal adjustment all contracting parties must make to accommodate this initially non-intuitive facet of our laws. While corporations can make this adjustment without any real difficulty, individual consumers (read: humans) probably expend significant psychic
energy re-framing their approach to contracts once they've been the opposite party to an 'efficient' breach. I wonder if that non-intuitive re-framing is more socially costly in aggregate than the efficiencies gained in the breach. It's been shown that we as a species are hard-wired to feel wronged by broken promises. That we must re-wire against a biological default (beyond what is required simply to incorporate the increased risk f breach noted above) is most likely an uncaptured cost in most legal economists' analyses.

Nathan Richardson

Interesting comment. I particularly like the your argument that the "biological default" actually reflects real underlying costs; I think this is very similar to what Prof. Ben-Shahar is arguing.

But it might boil down to an argument not against efficient breach, but simply that damages for breach aren't sufficient? For a breach to be efficient, it has to make all parties better off after a compensatory side payment is made to the original promisee by the breaching party, and this often includes more than just a straight refund.

In the example in the post, the bike shop gives you your money back plus a coupon. In essence, you're saying that the coupon isn't enough to compensate you for these adjustment and "psychic" costs. (also, explaining these "psychic" costs might be exactly what Prof. Ben-Shahar is getting at) If true, you could theoretically sue and claim reliance damages. Efficient breach says that even if you sue, and win, your measure of damages should be the same regardless of whether you can characterize the breach as willful.

In other words, for breach to be Pareto-optimal, the side payment has to be enough to make you no worse off than you were before. If it's not enough, breach still might be Kaldor-Hicks efficient, but the law doesn't consider that to be enough since you're the promisee.

Of course, for consumers it's rarely if ever going to be worth suing to get adequate compensation. Breachers have an incentive to give you a remedy that falls short of compensating you (but by less than your perceived litigation costs). This is balanced by reputational costs, but probably not to the extent that consumers get full compensation for reliance in most cases.

In other words, your comment might (I think) be rephrased to say that efficient breach is fine in theory, and fine for large deals between sophisticated players, but doesn't work for consumer transactions because of litigation expenses (and other transaction costs).

To the extent that this is what you mean (and I may be mischaracterizing it), I think it has to be right, but it doesn't answer the question of why we have this deep emotional reaction to breach, or why we treat willful breach differently in the law.

Omri Ben-Shahar

The idea of efficient breach poses a wonderful dilemma. To every law-and-economics person it makes sense, and to everyone else it doesn't. It makes sense because it is in the interest of contracting parties -- efficient breach is a way to make money without altering the distributive outcome and without harming anyone else. And yet it doesn't make sense because there is a substantial amount of evidence that transactors, even sophisticated ones, reject it. The notion of "sanctity of contract" that is often invoked to justify the resentment to efficient breach is devoid of explanatory power. It does not tell us why a particular type of breach violates the sanctity while other types do not. In search of an "underpinning" for this notion--for an explanation why willful efficient breach is popularly perceived as wrong and punishable--my paper provides an information-based theory, as described in the main post above. It may well be that this theory is not truly needed, if we are ready to dismiss the opposition to efficient breach as simply wrongheaded. Some of this opposition might indeed be misinformed and irrational. but my own view is that we can do better than dismiss the opposition. A more nuanced economic account of efficient contracting demonstrates that the opposition to efficient breach has solid foundations in ... efficiency!

Kimball Corson

It is an interesting comment, indeed. However, I am left wondering if the basic rational for not penalizing willful breaches is simply not known or well enough understood and therefore undermined by inadequate laws and ill-considered sentiments. To the ill or uninformed, willful breach may indeed smack of something bad or close to it, but that is hardly a compelling argument, especially if other law is set right as it was regarding the recovery of attorneys´fees for breach in most jurisdictions.

Tim Cullen

Thanks for responding to my comments. I actually think that when more sophisticated agents inadequately compensate less sophisticated ones during an efficient breach such that it makes no economic sense to sue is reflective of a more widespread but separate phenomenon, outside the scope of this post.

@Mr. Richardson: in your penultimate paragraph, you nailed all the way up to the word 'because.' I'm not sure it makes sense to learn why exactly humans feel an emotional reaction to breach. What's important is that we learn to quantify it or learn the costs of de-emotionalizing (if that's a word) our response to breach in order to set our legal thresholds efficiently.

@Professor Ben-Shahar: I don't think opposition to breach is irrational (especially for individual actors)--I just think we undervalue the costs of remedying because our emotional response is hard to quantify.

Lastly, is there a link to the paper available?

Thanks for the stimulating conversation.

Uzair Kayani

I wonder if the emotional resistance to efficient breach would disappear if every contract explicitly stated that the promissor might breach and pay expectation damages. Alternatively, every contract could have a liquidated damages clause. Put differently, we could have a "warning label" on contracts.

People would then treat contracts the same way that they treat securities: they would be cognizant of the risks involved and not rely too much on performance. The emotional resistance to efficient breach might be a symptom of promisee over-reliance.

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