PETER GERHART ON GOOD FAITH: FOLLOWING A TRAIL OF BREADCRUMBS.

• Author: Gordley, James
• Position: Tribute to Professor Peter M. Gerhart

CONTENTS INTRODUCTION I. PETER GERHART'S APPROACH A. Preserving Equilibrium B. Acting in Good Faith 1. Providing Flexibility a. Discretion To Be Exercised According to a Standard b. Discretion That is Not Subject to a Standard 2. Promoting Cooperation a. Positive Duties of Cooperation b. Negative Duties of Cooperation II. OTHER CONCEPTIONS OF GOOD FAITH A. Good Faith as an "Excluder" B. The Good Faith as a Violation of Fundamental Principles of Interpretation C. Good Faith as a Recapitulation of Fundamental Principles of Interpretation D. Good Faith as Altruism E. Good Faith as Means of Promoting an Efficient Result CONCLUSION: GOOD FAITH AND FAIR EXCHANGE INTRODUCTION

Virtually every state recognizes that the parties to a contract are under a duty to act in good faith. According to the Restatement (Second) of Contracts: "Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement." (1) Scholars who have tried to explain that duty have become lost in a forest of difficulties. In Part II of this Article, we will see why. Peter Gerhart discussed the duty briefly in seven pages of Contract Law and Social Morality, (2) a book published shortly before his death. In Part I we will see how, if we follow the clues he left in these few pages, like the proverbial trail of breadcrumbs, they will lead us through the forest.

1. PETER GERHART'S APPROACH

   1. Preserving Equilibrium

      In Gerhart's view, the duty to act in good faith followed from a larger principle: that of preserving the "ex ante equilibrium" of an exchange:

      It is hard to imagine the institution of contracting without a concept like good faith. When applied to performance obligations, the basic concept is straightforward: because contracts leave so many performance questions unaddressed, each party must interpret its performance obligations using a method of reasoning that appreciates the best way of maintaining the ex ante equilibrium position of the parties .... Both parties agree on, and thus maintain, the performance obligations that [the] ex ante equilibrium bargain maintained. The concept of good faith interpretation, as implemented here, tells the parties what they must do to align their interpretations with the equilibrium the parties achieved through bargaining. (3) According to Gerhart, then: (1) there is an ex ante equilibrium in a contract of exchange, (2) which the parties achieved through bargaining and wish to preserve, (3) and a method of reasoning for deciding which terms will preserve it even though these terms were not expressly addressed in their contract.

      I have defended propositions like these elsewhere. I believe my understanding of them may be, in relevant respects, like that of Gerhart. He said, at least, that he was following "the path suggested by James Gordley," (4) which gives me too much credit. As he noted, "[t]he idea presented here has many ancestors." (5) Moreover, by extending the path, he showed how to explain the duty to act in good faith. As a first step in understanding his explanation, I will summarize how I understand the propositions on which it rests.

      First, there is an ex ante equilibrium in a contract of exchange. This idea has many ancestors. As I have described elsewhere, the idea of equality in exchange can be traced from Aristotle through medieval philosophers, such as Thomas Aquinas, through the so-called "late scholastic jurists" of the 16th and 17th century, such as Domenico Soto, Luis de Molina, and Leonard Lessius, to the natural law writers of the 17th and 18th century, such as Hugo Grotius, Samuel Pufendorf, and those they influenced, such as Robert Pothier. (6) It was only rejected confidently with the rise of the will theories of contract of the 19th century. (7) In speaking of "equilibrium," I believe that Gerhart endorsed a modern version of this traditional idea.

      The traditional idea is that a fair exchange is one in which the performance that each party is to make is equivalent in economic value to the one that he is to receive. (8) Proponents of this idea understood that each party personally puts a higher value on what he is to receive than what he is to give in return. Otherwise, the parties would not exchange. Nevertheless, the economic value of each party's assets remained the same, and in that sense the value of the performances was equal. At the time of the transaction, neither party became richer or poorer. He would thereafter if the value of the goods or service he had exchanged rose or fell. But that risk was considered to be inherent in the decision to buy or sell, and it fell upon each of the parties. Soto said, "as the business of buying and selling is subject to fortuitous events of many kinds, merchants ought to bear risks at their own expense, and on the other hand, they may wait for good fortune." (9) According to Lessius, "as they may gain if they receive goods at small expense, so they may lose if the expense was disproportionate or extraordinary." (10) Each party was compensated for taking the risk that he would lose later on by the chance that he would gain. (11)

      A corollary was that the other terms of the contract should preserve equality. If the seller does not warrant his goods against defects, the unwary buyer will pay a sound price for an unsound commodity. The seller can waive the warranty but only if he reduces the price to reflect the risk that the goods are defective. (12) The exchange is equal as long as each party is compensated for the risks that he assumed. In Gerhart's words, the contract is in equilibrium ex ante. (13) Ex post, there will be winners and losers. Ex ante, the contract is fair in the same sense as a fair bet.

      The second proposition is that the parties arrive at this equilibrium through their own negotiations or bargaining. I understand this proposition to mean that they will do so even if neither of them gave a thought to fairness. Gerhart may not. He believes equilibrium is produced by "other-regarding or values-balancing reasoning" in which each party "appreciate[s] both parties' private projects but d[oes] not know which private project would be favored by the reconciliation of values." (14) "The other-regarding person does this by means of the thought process behind the veil of ignorance, a thought process that ensures that the appraisal of conflicting values is neutral...." (15) "[T]he veil of ignorance [i]s the core concept that other-regarding persons will undertake when they have made promises." (16)

      He took the idea of the veil of ignorance from John Rawls. In Rawls's theory of justice, a list of liberties to belong to each citizen is drawn up by their hypothetical representatives behind a "veil of ignorance," which prevents them from knowing what purposes the members that they represent wish to pursue. (17) I believe that Rawls's use of the "veil of ignorance" to explain justice is an illusion, but, nevertheless, Gerhart's use of it to explain equilibrium or equality in exchange is not. Rawls presupposes too much and too little of those who make decisions behind the veil of ignorance: too much, because he supposes that they represent people who have a "conception of the good" (18) without explaining what would make it "good" except that people in some way prefer it; (19) too little, because he supposes that they can make decisions about what form of government is best without regard to the context, culture, and characteristics of the people to be governed. (20) Even John Locke, who thought that government was formed by the people, believed that the people might choose to institute a monarchy, an aristocracy, or a democracy. (21)

      If, however, we imagine the contracting parties making decisions behind a veil of ignorance, we arrive at much the same idea of equality in exchange as the one just described. Equality or equilibrium means that neither party can tell in advance whether he is more likely to win or lose, much like gamblers who have made a fair bet. Gerhart recognized that " [pjarties implicitly bargain over the allocation of various risks. For any risk, we can presume that the parties allocate the risk to the low cost risk avoider...." (22) Behind the veil of ignorance, presumably, the parties will agree that whichever party assumes that risk will be compensated for doing so. And so we arrive at the idea of equality in exchange presented earlier.

      A difference, however, is that Gerhart, like Rawls, uses the metaphor of the veil of ignorance to determine what a person should do. That person's motivation for doing it, according to Rawls, is that he has "a capacity for a sense of justice," (23) and for Gerhart, is that he is an "other-regarding person." (24) Actual contracts are made by parties who are not behind a veil of ignorance. Unless we assume that they are high-minded, they will pursue their private interests. If they arrive at a fair result, an "equilibrium," then we must explain how self-interested parties are able to do so. If they will not, then parties behind a veil of ignorance will be unable to supply terms that maintain an equilibrium that never was.

      In my view, to quote Adam Smith: each person "intends only his own gain," and yet "he is ... led by an invisible hand to promote an end which was no part of his intention." (25) The end of which I am speaking, however, might have surprised Adam Smith. It is to make a contract on terms that are fair to the other party.

      We can see why if we consider how the traditional idea was once understood. Its proponents assumed that the exchange is made in a competitive market. Consequently, the terms on which each party contracts will be as good or better than the terms on which others are trading. The price that preserves equality will be the market price. (26) That price represents traders' estimate of what we would call the expected value of the goods exchanged. This understanding of equality is like that of...