Fault in contract law.

• Author: Posner, Eric A.

A promisor is strictly liable for breaching a contract, according to the standard account. However, a negligence-based system of contract law can be given an economic interpretation, and this Article shows that such a system is in some respects more attractive than the strict-liability system. This may explain why, as a brief discussion of cases shows, negligence ideas continue to play a role in contract decisions.

INTRODUCTION

Anglo-American contract law is said to be a strict-liability system, but it could just as well be a fault-based system. Indeed, one can make a plausible case that a fault-based contract law would be superior to the strict-liability system. A fault-based system would result in courts enforcing optimal contracts more systematically than they do currently--if courts could implement the system with sufficient accuracy. The disadvantage of such a system is that courts would need to make difficult inquiries and could make more errors. The balance between the advantages and disadvantages is hard to determine.

As many authors have noticed, although Anglo-American contract law is usually called a strict-liability system, it does contain pockets of fault. Fault-like notions, such as good faith and best efforts, recur in the cases, and terms are often implied in order to ensure that obligations are reasonable rather than absolute. These doctrines reflect some of the advantages of the fault-based system, and strengthen the theoretical basis for the claim that fault ought to play a role in contract law. (1)

This Article has three Parts. In Part I, I lay out the case for a fault-based contract law. In Part II, I show ways in which the idea of fault is reflected in doctrine--not in all doctrine, but in some cases and rules. In both Parts, I will limit my discussion to fault in the decision to perform or breach: the question is whether the promisor's breach may be excused because the breach was not his fault, or was not negligent. I will for the most part ignore negligent representation and other doctrines related to the decision to enter a contract in the first place. (2) I also use a very simple model; a more complex model could well lead to different results.

I conclude that the case for strict liability for breach of contract is not particularly strong, and so we should not be surprised that so many pockets of fault-based liability exist in contract law. The main puzzle that emerges from the discussion is why contract law puts the burden on the wrongdoer to show that he was not at fault in order to avoid paying damages, while tort law puts the burden on the victim to show that the wrongdoer was at fault in order to obtain damages. I discuss this puzzle in Part III.

1. THEORY

   1. A Model

   Consider a contract where Buyer values a good at V, Seller's cost in producing the good is c, with probability q ("bad state of the world"), and [c.sub.L] with probability (1 - q) ("good state of the world"), where [c.sub.H]> V > [c.sub.L]. Buyer pays in advance a price, p, such that p just covers Seller's expected costs. Prior to performance, Seller can incur some cost x; if Seller incurs this cost, q drops to 0--in other words, Seller can ensure that performance will be at the low cost. The contract is made at time 0; Buyer pays at time 1; Seller invests x, or not, at time 2; Seller's cost of performance (c) is determined at time 3; and Seller performs or breaches at time 4. Damages (d), if any, are paid at time 5. Renegotiation is assumed to be impossible.

   The conventional analysis of this setup in the literature is as follows: (3) Performance is desirable if and only if the cost is low (the good state of the world), because V > [c.sub.L] and V < [c.sub.H]. The investment x is desirable if and only if x is less than the cost savings from reducing the probability of c, from q to 0. Those cost savings equal the social benefit of the transaction being consummated (generating V - [c.sub.L]) where otherwise it would not go through (with probability q). Thus, efficient investment requires that x < q(V- [c.sub.L]).

   Optimal incentives can be provided easily in this setup. To ensure efficient performance or breach, let Seller pay damages if she does not perform, and set those damages equal to V (d = V). This remedy also ensures efficient investment. Because Seller pays Buyer's lost valuation if Seller does not perform, Seller fully internalizes the cost of breach. Here, Seller will invest x as long as x < q(V - [c.sub.L]), as this reduces expected costs from qV + (1 - q)[c.sub.L] contract in the first place. (2) I also use a very simple model; a more complex model could well lead to different results.

   I conclude that the case for strict liability for breach of contract is not particularly strong, and so we should not be surprised that so many pockets of fault-based liability exist in contract law. The main puzzle that emerges from the discussion is why contract law puts the burden on the wrongdoer to show that he was not at fault in order to avoid paying damages, while tort law puts the burden on the victim to show that the wrongdoer was at fault in order to obtain damages. I discuss this puzzle in Part III.

1. THEORY

   1. A Model

      Consider a contract where Buyer values a good at V, Seller's cost in producing the good is c, with probability q ("bad state of the world"), and [c.sub.L] with probability (1 - q) ("good state of the world"), where [c.sub.H]> V > [c.sub.L]. Buyer pays in advance a price, p, such that p just covers Seller's expected costs. Prior to performance, Seller can incur some cost x; if Seller incurs this cost, q drops to 0--in other words, Seller can ensure that performance will be at the low cost. The contract is made at time 0; Buyer pays at time 1; Seller invests x, or not, at time 2; Seller's cost of performance (c) is determined at time 3; and Seller performs or breaches at time 4. Damages (d), if any, are paid at time 5. Renegotiation is assumed to be impossible.

      The conventional analysis of this setup in the literature is as follows: (3) Performance is desirable if and only if the cost is low (the good state of the world), because V > [c.sub.L] and V < [c.sub.H]. The investment x is desirable if and only if x is less than the cost savings from reducing the probability of c, from q to 0. Those cost savings equal the social benefit of the transaction being consummated (generating V - [c.sub.L]) where otherwise it would not go through (with probability q). Thus, efficient investment requires that x < q(V- [c.sub.L]).

      Optimal incentives can be provided easily in this setup. To ensure efficient performance or breach, let Seller pay damages if she does not perform, and set those damages equal to V (d = V). This remedy also ensures efficient investment. Because Seller pays Buyer's lost valuation if Seller does not perform, Seller fully internalizes the cost of breach. Here, Seller will invest x as long as x < q(V - [c.sub.L]), as this reduces expected costs from qV + (1 - q)[c.sub.L] to [c.sub.L]. And if Seller does not invest x because x is high, Seller will perform in the good state of the world and not perform (instead paying damages) in the bad state of the world.

   2. Fault

      As has frequently been noted, this analysis does not depend on any notion of fault. Seller is strictly liable for breach of contract.

      However, we can imagine a fault-based approach that yields the same behavior. Suppose that Seller is liable for breach of contract only if her breach was the result of fault or willful action. Let us use the following definitions:

      Seller's breach is willful if the cost of performance is less than Buyer's valuation (that is, c = [c.sub.L]); efficient breach is not willful.

      Seller's breach is negligent if the cost of performance is higher than Buyer's valuation (that is, c = [c.sub.H]), and Seller could have taken a cost-justified action to prevent this from happening (that is, x < q(V- [c.sub.L])) but did not. In other words, breach, whether or not efficient, after failure to engage in efficient investment is negligent.

      Seller's breach is inadvertent (not her fault, and not giving rise to liability), if the cost of performance is higher than Buyer's valuation (that is, c = [c.sub.H]), and Seller could not have taken a cost-justified action to prevent this from happening (that is, x > q(V- [c.sub.L])). Efficient breach after efficient investment is not negligent. Seller pays damages only if the breach was willful or negligent.

      It can be shown that this fault system produces efficient performance at time 4 and efficient investment at time 2. Efficiency requires that performance occur if and only if V > c, that is, where c = [c.sub.L]. Suppose that Seller engaged in efficient investment at time 2. Her cost is then [c.sub.L], and at time 4 she will perform if d > [c.sub.L].

      Now consider whether Seller will engage in efficient investment at time 2. If Seller does, she incurs cost x; and she will perform if d > [c.sub.L] (see above), resulting in cost [c.sub.L]. Thus, the cost of investment is x + [c.sub.L]. If Seller does not engage in investment, she does not incur cost x. In the good state of the world (c = [c.sub.L]), she will perform, at cost [c.sub.L], because [c.sub.L] < d. In the bad state of the world (c = [c.sub.H]), she will breach and pay d. Thus, her cost of not investing is qd + (1 - q)[c.sub.L]. She will invest only if it is cheaper than not investing, that is, where x + [c.sub.L] < qd + (1 - q)[c.sub.L], or x < q(d - [c.sub.L]), which is also the condition for efficient investment if d [greater than or equal to] V. (4)

   3. A Comparison: Strict Liability Versus Negligence

      Although the strict-liability system and the fault system lead to the same outcome--efficient breach and efficient performance--they have several important differences.

      First, the fault system requires the court to make the negligence determination, which might be difficult. The strict-liability system does not. In...