MORAL DIVERSITY AND EFFICIENT BREACH.

Author:Seligman, Matthew A.
 
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Most people think it is morally wrong to breach a contract. But sophisticated commercial parties, like large corporations, have no objection to breaching contracts and paying the price in damages when doing so is in their self-interest. The literature has ignored the profound legal, economic, and normative implications of that asymmetry between individuals' and firms' approaches to breach. To individuals, a contract is a promise that cannot be broken regardless of the financial stakes. For example, millions of homeowners refused to breach their mortgage contracts in the aftermath of the housing crisis even though doing so could have saved them tens or even hundreds of thousands of dollars. Their moral beliefs led homeowners to forgo opportunities for efficient breach that firms would have seized, thus exacerbating already swelling wealth inequalities.

This Article explains this phenomenon, identifies its consequences, and examines strategies to address it. Neither ex post judicial interventions (such as adjusting the remedies for breach) nor traditional ex ante regulatory interventions (such as disclosure requirements) will effectively address the problem. Instead, the most promising approach is a novel solution based on the framework of choice architecture: requiring contracts to include an express term creating an option to exit the contract and pay a fee equivalent to expectation damages. An express exit term elevates an implicit legal option into an explicit contractual option, reframing the moral choice so individuals would perceive exiting the contract as a morally permissible performance of their promise rather than a morally forbidden breaking of it. The presence of that exit term thereby aligns individuals' perceptions of their moral obligations under the contract with sophisticated firms' approaches to breach.

The Article concludes with new empirical evidence that demonstrates the practical impact of an exit clause. It presents the results of two experimental studies I performed that demonstrate the effectiveness of a mandatory exit clause in reducing the effects of the asymmetry between individuals and firms. Those results show that exit clauses could have substantial practical implications for the regulation of contracts in contexts like consumer and mortgage contracts.

TABLE OF CONTENTS INTRODUCTION I. THE MORAL FOUNDATIONS OF CONTRACT LAW A. Contracts as Promises and the Morality of Breach B. Convergence Theory and the Revisionist Move II. THE ASYMMETRY IN MORAL BELIEF ABOUT BREACH A. Individual Moralist Performers B. Sophisticated Holmesian Breachers III. NORMATIVE IMPLICATIONS OF THE ASYMMETRY IN MORAL BELIEF ABOUT BREACH A. Economic Efficiency B. Fairness and Distribution IV. ACCOUNTING FOR THE ASYMMETRY IN CONTRACT LAW A. The Limits of Ex Post Judicial Intervention 1. Adjusting the Damages Measure 2. Adopting Specific Performance B. The Limits of Ex Ante Disclosure Requirements C. The Promise of Mandatory Exit Clauses 1. Exit Clauses As Promises-in-the-Alternative 2. Experimental Evidence on Exit Clauses CONCLUSION INTRODUCTION

Individuals and firms have sharply different moral views about whether it is permissible to breach a contract. Most people think it is wrong to breach even if it is in their economic interest to do so. (1) Contracts, in the eyes of many, are promises. When you enter a contract, people believe, you make a promise to perform. (2) And because people also tend to think that breaking a promise is wrong, (3) they think they are subject to a corresponding moral obligation to perform the contract. (4) As a result, contracting parties who hold this view will perform their express obligations under a contract even if they would be better off economically by breaching and paying damages to their counterparty.

But firms often don't hold that view. Instead, they typically view a contract simply as a legal obligation to perform, the violation of which is not a moral wrong to be avoided but rather a legal contingency to be navigated. (5) Justice Holmes famously claimed 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." (6) According to the view associated with Holmes, (7) law provides the remedy for breach of contract through expectation damages, and submitting to that remedy exhausts both the moral and legal liability of a breacher. For a Holmesian firm, then, there is no further moral obligation to perform rather than to breach and pay damages. (8) As a result, the Holmesian firm will breach and pay damages whenever it is in its interest to do so.

This asymmetry in moral belief has profound practical consequences. Consider the aftermath of the housing crisis in 2008. Mortgage contracts require monthly payments of the principal and interest that, over the life of the loan, amount to much more than the original loan amount. After housing prices plummeted in 2008, millions of homeowners owed more on their mortgages than their houses were worth. (9) Their mortgage contracts were "underwater," and it would have been financially beneficial for many of them to breach those contracts. This was particularly true because many of the contracts were from nontraditional loans, which had become popular before the crisis. (10) Those loans often included balloon payments, teaser interest rates that increased dramatically after an introductory period, and other features that made those loans especially costly after the first several years of the loan term. (11) Underwater homeowners thus faced a choice between continuing to make rapidly escalating monthly payments and breaching their mortgage contract. The primary consequence of breach is that the borrower must turn over the house that served as collateral for the loan. (12) When the house is worth less than the balance of the mortgage, and thus worth much less than the homeowner would ultimately have to pay over the life of a nontraditional loan because of interest, the homeowner often best serves her financial interests by breaching the mortgage contract and turning over the house.

Yet hundreds of thousands--or more--of underwater homeowners refused to breach their mortgage contracts. The numbers are staggering. Research by the Federal Reserve indicates that only about 5% of households with negative equity (that is, with underwater mortgages) who could afford to make their monthly payments (13) chose to default on their mortgages. (14) If a million homeowners could have saved $100,000 each by walking away from their underwater mortgages, in aggregate their choices not to do so cost them $100 billion. Homeowners incurred that astounding cost--to the direct benefit of large financial institutions--in large part because of their perceived moral obligation to make good on the promise they made to pay their mortgage. (15) Those same large financial institutions, by contrast, breached their own contractual obligations--both to the homeowners who were going underwater and to the investors to whom they sold securitized mortgages. (16)

This Article thus examines a question the literature has neither recognized nor addressed: how the law and regulation of contracts should account for the fact that legal actors are guided by differing views about the moral permissibility of breach. The Article proceeds in four Parts. Part I situates the phenomenon of moral diversity within the philosophical and economic debate about the morality of breach. It shows that the debate revolves around a disagreement about the moral scope of the promise generated by a facially unqualified contract--that is, a contract that states a primary obligation to perform without providing an explicit alternative like a liquidated-damages clause. Some theorists view such contracts to give rise to categorical promises, but others take those contracts to give rise only to promises-in-the-alternative to perform or pay. That disagreement about the moral scope of a promise, in turn, mirrors the moral diversity among contracting parties: individuals, but not firms, think that a contract generates a promise to perform, not a promise to perform or pay.

Part II presents recent empirical research revealing the asymmetry in moral belief among different types of parties regarding the moral permissibility of breach. Section II.A presents the experimental evidence supporting the conclusion that individual actors tend to view breach as immoral. It extracts from that research two further important conclusions: first, that even among individuals there is substantial heterogeneity in moral belief about breach; and second, that individuals tend to determine the moral scope of their contractual promise by reference to the express terms of the contract. Section II.B presents the evidence that sophisticated parties like commercial firms tend to view a contract as generating alternative options to perform or to pay. It presents both the experimental evidence on the breaching beliefs and behavior of sophisticated commercial actors and the theoretical considerations that have led many scholars to conclude that such commercial actors tend to behave as Holmesians.

Part III argues that this asymmetry is normatively problematic. This Part addresses two normative frameworks: economic efficiency, and fairness and distribution. Section III.A argues that the existing legal framework, in conjunction with individuals' moral beliefs, results in those individuals forgoing efficient breaches. That legal framework thus leads to outcomes that are not Pareto optimal and fails to maximize social welfare. Section III.A then considers and rejects the counterargument that some of the forgone breaches would have been opportunistic but not efficient. Section III.B argues that the existing legal framework is distributionally unfair because it facilitates sophisticated commercial actors to systematically exercise economically...

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