Investment, information, and promissory liability.

AuthorJohnston, Jason Scott
PositionResponse to article by Omri Ben-Shahar in this issue, p. 1829

In Contracts Without Consent: Exploring a New Basis for Contractual Liability, (1) Omri Ben-Shahar, a talented and creative economic analyst of law, advocates a principle--which he calls the "no-retraction" principle (2)--that is so at odds with the existing structure of the common law of contracts (3) as to basically turn contract law upside down. Ben-Shahar's no-retraction principle would radically alter the line between agreement and no agreement, between liability for unkept promises or assurances and no liability for such unkept promises or assurances. Indeed, under a no-retraction regime, there would be no line between agreement and no agreement, and contractual liability could exist even in the absence of any communication (or what Ben-Shahar calls a "proposal") (4) at all. Transactions could be forced upon parties who want nothing to do with them--either because they've walked away from failed negotiations or because they were never in any negotiations to begin with--but only on the terms that were or would have been demanded by the unwilling party. By incurring reliance expenditures early in a contractual negotiation (or, apparently, before a negotiation had even begun), a relying party could hold the other negotiating party liable for those reliance expenses, regardless of whether those expenses were incurred in reliance upon a promise. (5) Ben-Shahar defends his proposal both as representing "a conceptual advance" (6) and as creating superior economic incentives relative to the existing American common law doctrinal regime. (7) He says that the no-retraction regime is a conceptual advance because it is "a 'natural' legal platform for tracking the progress of [contractual] negotiations" that "provides a more flexible set of tools for transforming the understandings between parties into legal obligations." (8) He says that the no-retraction regime is superior on efficiency grounds to the existing doctrinal regime because it would encourage precontractual reliance where it is socially desirable to do so, while at the same time avoiding any chilling effect on the incentive to enter and make proposals in negotiations. (9)

In this brief Commentary, I take Ben-Shahar's no-retraction proposal as an opportunity to compare and contrast two alternative economic approaches to thinking about the question of what sort of statements or actions ought to trigger contractual liability. Although this question is often referred to as the issue of "precontractual liability," (10) it is in fact much more general, involving the fundamental question of why it is ever economically desirable to attach legal liability to a party's failure to transact. I argue that, while Ben-Shahar's proposal may indeed encourage efficient early reliance, its likely inefficiency in discouraging negotiations from even beginning and in encouraging inefficient and unconsented transactions far outweighs its potential efficiency benefits. Thus, Ben-Shahar's no-retraction regime is decidedly inferior on efficiency grounds to the current doctrinal approach.

Along the way, I hope to persuade the reader of a much more general point. Ben-Shahar's conceptually confusing, practically impossible, and instrumentally unwise no-retraction idea is not the result of bad economics, but of having taken a very rigorous and sound economic model far too seriously and immodestly. That model--known either as "the reliance model" (in law and economics) or the "optimal investment model" (in economics)--thinks that the fundamental problem solved by contractual law is to get the correct incentives for people to make investments that increase the value of contractual transactions. (11) It worries that, if the law doesn't give people a right to recover their reliance investments when the transaction doesn't occur because the other party backs out, then they will have an inadequate incentive to make such investments. Providing them an automatic right to recover fully compensatory damages in such an event, however, will give people no incentive to economize on reliance investments.

While this may seem to suggest that all that we've gotten from the model of reliance is the revelation of yet another doctrinal dilemma, as I explain in more detail in the first Part, the model of reliance also suggests a solution. The problem with Ben-Shahar's no-retraction proposal lies not with the model of reliance that it is based upon. The problem with Ben Shahar's proposal is that it forgets that there is a huge difference between finding that a particular liability regime can fix a particular, limited problem identified by such a formal (that is, mathematical) model and advocating that regime as generally superior to the existing doctrinal system. The problem is that, like any model, the model of reliance is limited and illuminates only part of the problem posed by the question of what sort of statements or actions ought to trigger contractual liability. It is surely true both that contract remedies do cut the risk to people of investing in the cooperative ventures that we call contracts and that it sometimes may be desirable for people to begin to invest earlier, rather than later, in such ventures. Ben-Shahar's no-retraction regime, like other proposals devised by economists, (12) does cut the risk of investing to increase the value of a contract and then being held up by a party who refuses to bear her fair share of that investment. But along the way, it creates an incentive for people to incur early reliance expenses solely in order to foist highly inefficient contracts upon other people, people with whom they may not even have been bargaining. It thus undermines a basic economic underpinning of contract law: the promotion of efficient, net-value-maximizing exchange.

Ben-Shahar's no-retraction regime also mistakes the reliance problem, which clearly is part of the problem raised by precontractual liability cases, for the whole problem. The question of when contractual liability ought to attach to promissory statements is not only about how people invest (or don't) to increase the value of cooperation. It is also about the incentives people have in attempting to discern whether cooperation is mutually beneficial in the first place. Precontractual liability effects incentives in dealmaking, incentives not regarding reliance investments that increase the size of the pie, but incentives to invest in order to acquire and transmit information about the likelihood that there is any pie to split in the first place. The model of reliance does not capture those incentives. It was not designed to do so.

An alternative model, which I developed some years ago, (13) does address those incentives and, in so doing, tends to indicate that the existing doctrinal structure accords quite closely with what an informationally efficient regime would look like. (14) In this Commentary, after discussing the analytical development of the reliance model and Ben-Shahar's application of it in devising his no-retraction regime, I review my alternative model and its conclusions. I do so not to prove that my approach--which may be called simply "the bargaining model"--is "better" than Ben Shahar's reliance model. Neither model captures the whole story. By comparing these approaches, one sees that they are complementary, not competitive. More importantly, one sees also that any proposal, such as Ben-Shahar's, that immodestly asks a model to do more than it was ever designed to do is bound to be wrong.

  1. THE MODEL OF RELIANCE IN THE ECONOMIC ANALYSIS OF CONTRACT LAW: ITS REMEDIAL BEGINNINGS

    The model of reliance had its beginnings, as did the economic analysis of contract law more generally, in the analysis of contract remedies. (15) These beginnings may be illustrated with a simple buyer-seller example. As every contracts student learns, when the seller's opportunity cost is less than the valuation that the buyer places on a good or service, then joint performance--the seller's production and delivery of the good and the buyer's payment of the promised price--makes each party better off than she would be without such a deal and generates a net increase in social value.

    In a more complicated example, a swimwear manufacturer that has built up brand loyalty may wish to extend the value of that intangible asset to suncare products. But this swimwear company does not have any experience or expertise in making such products and hence is interested in contracting with a company that does have such expertise. Joint performance in this example means that the swimwear company will not only license its trade name for use on the new suncare products, but will also cooperate in marketing and promoting the new suncare line. The suncare company, for its part, must produce a suncare product and packaging that will succeed on the market. The gain from successful cooperation is a mutually profitable new product line.

    In each of these examples, for gains from exchange to be realized, one or more of the parties may need to incur costs that may not be recoverable unless the two contracting parties actually cooperate by performing. In the first example, the seller may be producing goods tailored to the particular buyer's needs and so will recover only a portion of the cost of production by reselling if this particular buyer fails to perform. In the second example, at least some of the money spent by the swimwear company in promoting a new line of suncare products will be lost if the particular line being promoted is never produced and brought to market. Similarly, some fraction of the money spent by the suncare company in designing and testing a new suncare product will be lost if the swimwear company backs out of the deal and refuses to license the use of its name or to help in marketing and promoting the new product.

    In the legal literature on contracts, such costs are referred to as the parties' "reliance expenditures."...

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