Contracting for cooperation in recovery.

• Author: Klass, Gregory

INTRODUCTION 1. THE PRESENT LIMITATIONS OF CONTRACT LAW A. Underenforcement and Contract Duties To Cooperate in Recovery B. Compensatory Remedies 1. The Catch-22 2. Other Losses: Avoidable Harms, Delayed Recovery, and Litigation Costs 3. Liquidated Damages for Obstructive Breach II. EXTRACOMPENSATORY CONTRACT REMEDIES A. The Right To Terminate B. Adverse Inferences C. Penalties and Punitive Damages: A New Argument III. CONTRACTING FOR FRAUD LIABILITY A. An Early Foray: Rereading Seaman's Direct Buying Services v. Standard Oil B. Contracting for Fraud Liability C. Promissory Representations of No Intent To Obstruct D. The Limitations of Liability in Fraud IV. THE UTILITY OF CONTRACTUAL DUTIES NOT TO OBSTRUCT A. The Costs of Penalties and Punitive Damages B. Multipliers CONCLUSION INTRODUCTION

In 1984, the city of Richmond contracted with McDevitt Street Bovis for the construction of a new baseball stadium. The stadium was built, but a decade later the city discovered deterioration in the concrete tubes supporting the cantilevered roof, caused by McDevitt's breach of its contractual duty to fill the tubes with grout. The city sued, claiming both breach of contract and fraud, the latter based on false certificates of completion and other documents McDevitt had submitted. In Richmond Metropolitan Authority v. McDevitt Street Bovis, Inc., the Virginia Supreme Court held that because the contract required McDevitt to provide the certificates and other documents, misrepresentations in them might give the city a right to damages for breach, but could not give rise to liability in fraud. (1)

McDevitt is a good example of how courts police the border between contract and tort, protecting contract against, among other things, incursion by the punitive damages available in tort. But consider the holding's effect on Virginia contractors' decisions whether to submit accurate certificates of completion. Restricting recovery to the compensatory measures available in contract means that a Virginia builder who has breached its construction duties incurs little or no additional liability when it files a false certificate. The false certificate harms the purchaser first and foremost if it prevents her from discovering and recovering for nonconforming work. (2) To prove that harm--and even that the certificate was false--the purchaser must first show that the work was nonconforming, i.e., that but for the false certificate, she would have recovered for breach. But if the purchaser can show nonconforming work, then she already has a winning claim for breach of the underlying construction duty, which will compensate her for her losses. That is, if the purchaser can show that the false certificate harmed her, it did not. The Virginia Supreme Court's decision to limit recovery for false certificates of completion to the compensatory damages available in contract renders legal liability for breach of the certification requirement irrelevant.

This strange situation is not limited to certificates of completion in the building industry. The above argument, or one like it, applies to any contract term whose purpose is to make it easier for the promisee to discover and prove breach. Common examples include royalty reports, record-keeping requirements, certificates of compliance, and auditing rights. Such terms belong to a hitherto underappreciated genus of contract terms: duties to undertake acts that promote the other side's recovery for breach. I will use "obstruction of recovery" or "obstruction" to refer both to promisor actions that aim to avoid legal liability and to the failure to act in ways that would assist in the recovery of damages due where there is a duty to do so. I will use "cooperation in recovery," or simply "cooperation," to designate nonobstruction. (3) Where one side is particularly worried that she might be unable to recover for any breach, the other side might offer to undertake a contractual duty to cooperate in recovery--to agree, for instance, not to hide nonperformance, to keep complete records, or to provide information about performance.

But here's the problem: to recover compensatory damages for the breach of a duty to cooperate, a plaintiff must be able to demonstrate harm. The primary harm of an obstructive breach is that it prevents the promisee from recovering for breach of the underlying, or first-order, duty. Showing that harm requires independent proof of first-order breach--that the plaintiff was entitled to the damages she did not recover. But if the plaintiff can prove first-order breach, she can recover on that basis--which means that the obstructive breach has not harmed her. The upshot is a catch-22: a plaintiff can show obstructive harm only if she has not suffered it.

The way to break out of the circle is to attach extracompensatory remedies--remedies that are not tied to the plaintiff's verifiable losses--to obstructive breach. While the received wisdom is that optimal remedies for breach are always at or near the expectation measure, this cannot be so when it comes to duties to cooperate in recovery. (4) If such contract terms are to make a practical difference, they must be backed by punitive damages, penalties or other remedies neither conditioned on nor limited to compensation for harm done.

At present, courts will not enforce a penalty or punitive damages clause, which brings the analysis back to the potentially positive role of fraud liability. There is a longstanding debate within the courts and legal scholarship about whether parties should be able to contract out of liability for their fraudulent misrepresentations. (5) What has not been noticed is that many agreements are structured to opt into such liability using terms that require one party to represent that it is not in breach (by submitting, for example, a certificate of completion). When false, such representations not only breach the contract, but can satisfy the elements of fraud and support a claim for punitive damages. The contractual duty to share information about performance can be secured by the extracompensatory remedies available in fraud.

The existence of such contract terms suggests that parties want effective duties to cooperate in recovery. And their utility provides additional support for a thesis Ian Ayres and I have developed elsewhere: that the extracompensatory remedies available in tort can have "well-defined function[s] within the apparatus of the law of contracts." (6) Yet, as exemplified in McDevitt, many courts are uncomfortable with this incursion of extracompensatory remedies into the world of contracts and have found ways to exclude fraud liability for acts that are also breaches. The most recent trend in this direction involves an expansive reading of the economic loss rule to bar liability for fraud in the performance. This Article argues that such rulings are mistaken and that courts should recognize the positive role fraud liability can play in contracts. But the fraud solution is second best. A better solution would be an exception to the rules against penalties and punitive damages when those remedies are attached to contractual duties to cooperate in recovery.

Robert Scott and George Triantis have recently observed that "contracts scholars [have focused] principally on the substantive terms and not on the ability of the parties to regulate the procedural course of their future enforcement." (7) This is confirmed by the scholarly neglect of duties to cooperate in recovery. Such duties are attempts to regulate contract enforcement. This Article therefore fills in the picture of how parties contract for the case of breach. (8)

The Article's conclusions also bear on an old dispute about Holmes's famous dictum that "[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it,--and nothing else." (9) This "Holmesian heresy" is sometimes read to mean that, as far as the law is concerned, the promisor does not have a duty to perform, but an option to perform or pay damages. (10) Holmes himself rejected the alternative-promise reading, explaining that "the statement that the effect of a contract is the assumption of the risk of a future event does not mean that there is a second subsidiary promise to assume that risk, but that the assumption follows as a consequence directly enforced by the law, without the promisor's cooperation." (11) This Article examines what happens when the parties do make a "second subsidiary promise" to pay damages--or at least to cooperate in their recovery. Its surprising result is that mandatory rules limiting contract damages to compensatory measures mean that even when there is a second subsidiary promise, legal liability for its breach does not make a practical difference.

Part I of the Article describes why some parties, including promisors who know they might breach, should want to contract for legally enforceable duties not to obstruct recovery, and explains why currently available contract remedies--which are limited to compensation for actual losses--are often insufficient to enforce such duties. The core reason is the catch-22 described above: the promisee who can prove obstructive harm has not suffered it. In some cases, the effects of the catch-22 can be reduced through recovery for other harms of obstructive breach, such as delayed compensation and higher litigation costs, or by liquidating damages. But these alternative grounds of recovery do not sufficiently protect against obstruction in all contexts.

Part II considers three forms that contractually specified extracompensatory remedies for obstructive breach might take: the right to terminate the contract, an adverse inference with respect to first-order breach, and penalties or punitive damages. The right to terminate works only where the promisor attaches significant value to the continued existence of the contract, and where the promisee is...