Reflective Remedies.

AuthorJohnston, Mitchell Chervu

AUTHOR. Yale Law School, J.D. expected 2020. I am first and foremost grateful to Ian Ayres for teaching the class that inspired this Note, his encouragement to write this paper, and his supervision, support, and helpful comments throughout the project. I am thankful to Dhruv Ag-garwal, Simon Brewer, Zohaib Chida, Jamie Durling, Kristen Houston, Peter Kallis, and Daniel Strunk for their helpful thoughts on early drafts. I would also like to thank my family and friends more generally for their willingness to listen to the ideas that did not make it to print. Finally, thank you to Zohaib Chida, Patrick Hulin, Sarah Michael Levine, and the editors of the Yale Law Journal for their helpful editorial support and feedback.

NOTE CONTENTS INTRODUCTION 1151 I. REMEDIES AND DETERRENCE 1157 A. Uncertainty, Deterrence, and the 1159 Problem with Traditional Damages B. Punishment and Deterrence 1163 1. Strong and Weak Penalties 1163 2. Hybrid Penalties 1165 3. The Multiplier Principle and 1166 Supercompensatory Damages II. REFLECTIVE REMEDIES 1168 A. Defining the Proposed Remedy 1169 B. The Impact of Reflection 1171 C. Reflection of Multiterm Contracts 1172 D. Comparing Reflection 1174 III. WHEN AND WHERE SHOULD REFLECTION 1175 BE APPLIED A. Where Reflection Applies 1176 B. Reflection and Justice 1177 C. Efficiency Conditions for Optimality 1181 IV. POTENTIAL APPLICATIONS OF THE 1187 REFLECTIVE REMEDY A. Noncompete Clauses 1188 B. Refereed Bargaining 1189 C. Price Unconscionability 1191 D. The Implied Warranty of Habitability 1192 E. Reflection, Caps, Floors, and Noncontractual Policy 1193 CONCLUSION 1195 APPENDIX A: MODELING THE IMPACT OF REFLECTION 1197 A. A Model of Reflection 1197 B. Solution to the Model 1199 C. Interpretation of the Solution 1201 D. Risk Aversion and Reflection 1203 APPENDIX B: REFLECTION IN MULTIDIMENSIONAL SPACE 1206 A. Implementations of Multidimensional Reflection 1207 B. A Second-Best Solution to Multidimensional Reflection 1211 INTRODUCTION

Imagine you and your employer wish to negotiate a noncompete agreement. (1) And imagine you both agree to the maximum length for a noncompete agreement allowed in your jurisdiction. The problem, however, is that no one knows exactly what that length is. Instead, the jurisdiction you are in uses a balancing test to evaluate these agreements, (2) and while precedents set certain bounds on what might be permissible, they do not apply precisely to your particular circumstances.

This type of scenario is not an aberration; the application of the law is often uncertain. While some legal rules come in forms that are easy to apply, others are less straightforward. For example, restrictions on unconscionability, (3) anticompetitive contracts, (4) and actions that violate the duty of good faith (5) are all framed in abstract language that leaves room for uncertainty. Furthermore, enforcement is often far from consistent, even for relatively simple rules. As a result, individuals looking to obey the law often act under conditions of uncertainty, in which they are not sure whether their actions will or will not result in legal sanction. (6)

One solution would be to try to eliminate uncertainty in the law. But this task is often impossible in areas that we would like to regulate. Policy-makers struggle to formulate exactly which conduct should or should not be prohibited ahead of time. Moreover, exact rules, even if possible, can turn out to be undesirable. For example, a detailed code listing the maximum length of noncompetes for various professions would be cumbersome and would also limit the ability of the law to shift over time as new professions arise and existing ones evolve.

Of course, in some cases courts can slowly wring uncertainty out of the law through the creation of precedent without running into the problem of undesirable rigidity. Precedent, however, provides a highly imperfect solution because of its case-dependent nature. The inquiry about whether an individual building violates the implied warranty of habitability may tell us limited information about the exact application of that result to another building. Similarly, one decision on a noncompete clause applied to a particular profession, a particular state, and a particular time frame may be difficult to apply to another case with different facts. (7) While these precedents may shape the expectations of the parties and may determine the outer bounds of what is acceptable, in fact-specific cases precedent may fail to eliminate uncertainty.

This Note proposes an alternative means of mitigating the problems caused by uncertainty in legal rules. (8) In particular, it focuses on which damage remedies and contract modifications create optimal ex ante incentives when uncertainty is present. (9) I refer to these penalties as "reflective" remedies because they focus on penalizing defendants by an amount equivalent to their overreach.

Reflection is most effective when applied to rules that specify a maximum "reasonable" level of activity, thereby punishing individuals who take more extreme actions. Such rules may, for example, set a maximum price that can be charged for a good or service or limit the duration of a noncompete clause. Reflective remedies look to the amount by which the defendant exceeded this level and then double this amount when assessing the penalty. This symmetrically "reflects" the defendant's position across the maximum reasonable level. More formally, if x* is the socially optimal legal cap on some type of behavior (meaning that behavior at level z > x* violates the legal rule or standard) and the actor chooses level x* + y then, under reflection, the agent is "set back" by twice the amount of her illicit gain (by 2y) to x* - y. This is depicted in Figure 1. Her loss is symmetrical (and therefore proportional) to the level by which she exceeded the socially optimal point. Importantly, this reflection need not take the form of damages. Contractual terms may also be modified in a reflective manner. For example, a one-year noncompete clause can be "reflected" to six months if the court finds that nine months would be the maximum allowable restriction.

This Note claims that when certain conditions are met, reflective remedies better induce ex ante compliance with legal rules compared to other damages remedies that have previously been considered for dealing with the problem of uncertainty--such as the use of damage multipliers. In short, when the probability of detection of wrongdoing is high and individuals are likely to have expectations about what the law requires that are accurate on average, reflection is likely to provide optimal ex ante incentives. (10) These situations are likely to occur most often when two parties are closely monitoring the behavior in question (for instance, in a contract negotiation between two sophisticated parties) or when one party is negotiating with a large number of other parties and therefore at least one party is likely to detect overreach (for instance, in negotiations of consumer contracts or employment contracts). (11) Reflection forces individuals to choose behavior in the middle of their spectrum of beliefs about when the law will be applied. (12) Rather than encouraging individuals to be overly optimistic or pessimistic, reflection thus encourages individuals to choose their best guess about how the law will be applied. Therefore, under certain conditions, reflection will better incentivize ex ante compliance with the law. (13)

Note that I use maximum activity level and the socially optimal point interchangeably throughout the argument. The idea here is that under a standard economic analysis of legal rules we want to set the limits on conduct at the point that maximizes the total gain to society. (14) Thus, agreements should be banned if they exceed this point. Of course, for a variety of reasons, legal rules are often constructed such that the limits of what the law allows are not necessarily the behaviors which we wish for individuals to engage in consistently. (15) Still, reflection is a tool that exists to encourage individuals to choose the maximum of what is allowed. It should only be used when this maximum is actually socially desirable. Therefore, for the purpose of this argument the two notions are interchangeable.

The difference between ex ante compliance and ex post remedies matters to individuals--particularly those who have the least access to court-ordered justice. For example, courts have imposed the implied warranty of habitability to limit the ability of landlords to provide substandard housing. (16) This warranty requires landlords to maintain habitable property even if it is not specified in the lease. However, the warranty may raise rents in some cases, decreasing the housing stock that is available to low-income tenants. (17) The policy-maker must therefore balance two difficult pressures. She wants to set the floor to ensure that the housing provided is high quality while also balancing the need to not over-regulate the market and limit the availability of housing. However, even after setting this floor, the choice of remedy for violations can upset the balance that has been chosen. A penalty that is too harsh may cause landlords to overcorrect; a penalty that is too weak will encourage landlords to cheat by providing substandard housing. Thus, the choice of remedy is critical to protecting both the tenants who rent housing and the broader population of tenants in need of housing. In other words, a law-and-economics analysis in this case can be critical to preserving the distributional equilibrium that society has chosen. (18)

Before proceeding, it is also worth clarifying that this Note is about the terms of agreements, not the remedies for breach. (19) For example, it is concerned with what to do when the parties write a noncompete that violates the law of the jurisdiction because it is overly onerous. It is not...

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