Let us never blame a contract breaker.

Author:Posner, Richard A.
 
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Holmes famously proposed a "no fault" theory of contract law: a contract is an option to perform or pay, and a "breach" is therefore not a wrongful act, but merely triggers the duty to pay liquidated or other damages. I elaborate the Holmesian theory, arguing that fault terminology in contract law, such as "good faith," should be given pragmatic economic interpretations, rather than be conceived of in moral terms. I further argue that contract doctrines should normally be alterable only on the basis of empirical investigations.

I.

My thesis is that concepts of fault or blame, at least when understood in moral terms rather than translated into economic or other practical terms, are not useful addenda to the doctrines of contract law. I have borrowed this thesis from Holmes, who in The Common Law (and later in The Path of the Law) drew a sharp distinction between tort and contract law, so far as issues of fault or blameworthiness are concerned. (1) In the case of an accident giving rise to a tort suit, he thought the loss should lie where it fell, that is, on the victim, unless the injurer was at fault, that is, negligent, and the victim faultless, that is, not contributorily negligent. He thus disapproved, in general, of strict tort liability. But a complication in his analysis arose from his belief in "objective" standards of liability; negligence was the failure of the average person to take proper care, even if the defendant was below average in his ability to do so. (2) That belief was not a fatal defect in Holmes's fault-based theory of tort law, however; as Bernard Williams has reminded us, consequences, and not just states of mind, influence our moral judgments. "[I]n the story of one's life there is an authority exercised by what one has done, and not merely by what one has intentionally done." (3) So inability to meet society's expectations concerning care to avoid inflicting injury can, when injury results, be considered a species of fault.

But Holmes was wrong to think that the pockets of strict liability in tort law were inconsistent with a fault-based theory of that law. Strict liability is based on recognition that care is too limited a notion of the duty to avoid doing harm. If you keep a lion in your backyard to ward off intruders and he escapes and mauls someone even though you took every precaution to minimize the risk of escape, there is still the question whether the expected costs of keeping a lion (the risk of injury discounted by the cost of the injury if the risk materializes) exceeded the benefits. To classify an activity as "abnormally dangerous," thus making the applicable tort standard strict liability, is to adjudge those costs to exceed the benefits.

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 buy an option to perform or pay damages. (4) The option feature is particularly pronounced when the contract contains a liquidated damages clause. You are promising that you will either perform or pay the amount specified in the clause. As long as you pay the damages awarded by the court in the promisee's suit for breach of contract, whether they are specified in the clause or computed according to the principles of contract damages, no blame can attach to your not performing even if it was deliberate--even if, for example, you did not perform simply because someone offered you more money for the product or service that you had undertaken to supply in the contract and you did not have enough capacity to supply both the promisee and the new, more necessitous customer. (5) You have not really broken your promise, because what you promised (though that is not how the contract will have been worded) was either-or: not performance but either performance or compensation for the cost of nonperformance to the other party to the contract.

The fact that the victim of a breach of contract can sometimes obtain specific performance or some other form of injunctive relief might seem a great embarrassment to Holmes's option theory of contract. But it is not if we bear in mind that injunctive relief is possible only when the remedy at law--that is, damages--is unavailable. For in such a case the contractual undertaking loses its either-or character; instead of a promise of performance or damages, it is a promise of performance or nothing, and that is not a choice the promisee would have agreed to. In contrast, a general entitlement to specific performance would indeed make contract law fault based. A court would not be willing to command a nonperforming party to perform, on pain of civil and criminal contempt and potentially astronomical fines if he did not, without considering whether he was in some sense "at fault" in not performing--whether in other words the costs to him of performing would have exceeded the benefits to the other party. Moreover, a general entitlement to specific performance would thwart some efficient breaches. (6) If A breaks his contract with B to sell to C because C will pay more than the harm (which equals damages) to B from the breach, the breach increases the social product: B is no worse off, and A and C are both better off. But if B is entitled to specific performance, A cannot sell to C without paying B to agree to terminate A's contract with him, creating a bilateral-monopoly situation (of which more shortly).

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). The promise is to perform or pay damages, and so if you choose not to perform--even if you are prevented from performing by circumstances beyond your control--you must pay damages. It wouldn't make any sense to excuse you just because the cost of performance would exceed the benefits, for that would make the option nugatory.

Another way to understand this point is to note that an option has an insurance component. If you promise me either performance or some compensation in lieu of performance you are insuring me against the consequences of your nonperformance. As Holmes explained with characteristic directness,

[t]he consequences of a binding promise at common law are not affected by the degree of power which the promisor possesses over the promised event.... In the case of a binding promise that it shall rain to-morrow, the immediate legal effect of what the promisor does is, that he takes the risk of the event, within certain defined limits, as between himself and the promisee. He does no more when he promises to deliver a bale of cotton. (7) You will make such a promise--grant me such an option--if you are the cheaper insurer against the risk of nonperformance. Strict liability for nonperformance reduces transaction costs by optimizing risk bearing (the function performed in the tort setting by formal liability insurance).

The civil law approach to breach of contract is different from the common law approach. Liability is not strict; a party is in breach of his contract only if he "could reasonably have been expected to behave in a different way," that is, only if he was at fault in failing to perform. (8) And the victim's entitlement (to the extent actually honored) under civil law to specific performance discourages efficient breaches. (9) The duty of good faith--the common law version of which can, as we shall see, be explained in nonmoral terms--in civil law expands to include "[b]ad faith bargaining," (10) which may not have a pragmatic, nonmoral, justification.

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. (11) It is apparent which origin is more likely to produce efficient law. There is evidence that common law is indeed superior to civil law from the standpoint of promoting commercial activity. (12)

One might object to the common law rule of strict liability for breach of contract that a contracting party, at least if it is a corporation, either will be risk averse (because its shareholders can eliminate firm-specific risk by holding a diversified portfolio of stocks) or can buy insurance from an insurance company, and so it can have no need for an insurance component in its contracts. But even large corporations often buy a great deal of insurance; the reasons have to do with managerial risk aversion (a large part of a manager's wealth may be his firm-specific human capital), tax avoidance, and the deadweight costs of bankruptcy. (13) It is difficult, however, to buy market insurance against the risk of being the victim of a breach of contract, because the risk and its consequences cannot be calculated with the actuarial precision that insurance companies insist upon; (14) there is too much heterogeneity among contracts--too much uncertainty about the likelihood and consequences of a breach. The difficulty of insuring against breach of contract has been demonstrated in the current financial crisis by the near collapse of American Insurance Group (saved only by a federal bailout), which through credit default swaps and other devices had offered default insurance on a large scale.

Probing deeper, we can see that strict liability for breach of contract, too, is a sensible default provision, which allows the parties to specify excuses for failure to perform, such as force majeure. There are also default excuse provisions, such as impossibility and frustration, but the justification is economic rather than moral; they allocate risk as the parties could be expected to have done had they negotiated over the issue. (15)

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