The efficient performance hypothesis.

• Author: Brooks, Richard R.W.

INTRODUCTION I. MEANS AND AIMS OF CONTRACT ENFORCEMENT A. Assigning and Protecting Contractual Entitlements B. Counterfactual Aims of Contract Remedies II. PROMISOR'S AND PROMISEE'S ELECTION A. Promisor's Election and Efficient Breach B. Promisee's Election and Efficient Performance C. Remedial Choices and Consequences III. ETHICS AND ECONOMICS A. Positive Confusion B. Normative Clarity CONCLUSION INTRODUCTION

Law and economics scholarship has advanced a number of provocative arguments in the name of efficiency--from promoting insider trading to establishing markets for babies--but none is perhaps quite so controversial as the argument behind the efficient breach hypothesis. (1) The idea that legally obligated parties ought to be encouraged to breach their contracts when it is in their self-interest to do so would seem to threaten a greater "social interest in the stability of promises as a social and economic institution." (2) But as efficient breach advocates point out, promoting economic and social welfare is the very basis of the hypothesis. Furthermore, efficient breach does not, as often suggested, disallow enforcement of inefficient contracts. Rather, it supposes a system of strict enforcement of all contracts, regardless of their efficiency. (3) Enforcing a contract does not necessarily require the performance of the specified action; it may instead entail the imposition of penalties, (4) though as Richard Craswell observed, "this form of enforcement is rarely considered in the philosophical literature on promising, which usually assumes that promises must either (1) oblige the promisor to perform the promised actions, or (2) have no moral force at all." (5) Efficient breach of contract occupies "an intermediate level of moral force." (6)

Moral force at this intermediate level, and no higher, was exactly what Justice Oliver Wendell Holmes identified in his celebrated essay The Path of the Law. (7) "The duty to keep a contract at common law," Holmes proposed, "means a prediction that you must pay damages if you do not keep it,--and nothing else." (8) From there followed his option theory of contract, which according to Richard Posner clarified the traditional view whereby "'duty' is vague, abstract. Holmes pointed out that in a regime in which the sanction for breach of contract is merely an award of compensatory damages to the victim, the entire practical effect of signing a contract is that by doing so one obtains an option to break it." (9) Holmes supported his proposition with an extensive discussion of the old English case Bromage v. Genning. (10) While the court did voice concern about subverting the promisor's intent that it be his choice to pay damages or perform, (11) it also expressed concern that if the promisor were ordered to perform and he refused, there was no remedy other than to imprison his body. (12) We are reminded that promisors have always had options. "Perform or pay" and "perform or prison," however, merely describe economic choices; they say nothing about the legal character of these options. The power to perform or pay is not the same as the right to perform or pay. All duties, at some level, are optional, making "perform or pay" a rather weak conception of duty. I am of course not the first to observe this gossamer notion of duty (Holmes himself expressed this criticism). (13) But I shall advance here that it has little to do with economic efficiency.

Avoiding specific performance of inefficient contracts creates value. Think of it as a contractual opportunity, which--like partnership opportunities--can be viewed as belonging to the joint venturers (the promisor and promisee in this case). Without saying more, it remains morally ambiguous to whom the gains of this opportunity should go, or whether they should be shared and, if so, how. Efficiency considerations offer equally ambiguous guidance. Even a concern for allocative efficiency alone does not provide an a priori justification for giving promisors the gains of nonperformance. The fact that nonperformance of an existing contractual obligation is sometimes efficient--which is to say, it sometimes produces more gains than performance--is analytically distinct from a rule giving the promisor an option to acquire those gains.

Here is where the controversy over the efficient breach hypothesis lies. It is not in the suggestion that some promises need not be kept. By almost every normative criterion, not all promises should be kept. Doctrine excusing performance for frustration of purpose, for instance, does not provoke moral outrage. What provokes disapproval of the efficient breach hypothesis are strong moral sentiments that nonperformance of a contractual promise is not a right, but in fact is a wrong, and that promisors should not profit from the unilateral exercise of their power to perform or not. Yet that distribution of profit and power is not required for allocative efficiency.

This Essay develops an efficient performance hypothesis, structured to give the promisee the right to compel performance and capture all or some of the profits when nonperformance is elected. The key to this approach is situating the promisee to weigh the marginal costs and benefits of performance. That is exactly what the efficient breach hypothesis accomplishes with regard to the promisor. For the promisee, the efficient performance hypothesis can work just as well by giving her the choice between performance and disgorgement of the promisor's cost as the remedy for breach. (14) Indeed, this hypothesis predicts the same allocatively efficient outcome as the efficient breach hypothesis but offers a distribution of rights and gains that is more consistent with the moral sentiments described above.

Allocative efficiency does not call for any particular allotment of rights and surplus. The First Theorem of Welfare Economics established this claim long ago. (15) With specific reference to contract, scholars have shown generally (and quite dramatically) that efficiency is achievable over a continuum of allocative rights and distributions of surplus--the possibilities are literally infinite. (16) The purpose of this Essay, however, is not to reiterate the basic principles of welfare economics or the compelling work on the optimal design of liability rules. Rather, it is to show that efficiency is consistent with more robust notions of contractual duty than those employed by the Holmesian bad man. (17) Stronger forms of enforcement, such as giving the promisee the right to elect specific performance or supracompensatory damages, can allow for optimal allocation of resources while achieving a higher degree of moral force than the intermediate level associated with efficient breach.

Part I lays out the basic taxonomy (and derived rules) of entitlement assignment and protection set forth by Guido Calabresi and Douglas Melamed as well as the contract damage scheme suggested by Lon Fuller and William Perdue. Together these approaches introduce the fundamental ways in which courts may combine various rules with damage awards in crafting a remedy. Part II then develops the structural framework of the Essay. This framework associates contractual enforcement with the triple {e, d, m}, in which e represents the entitlement holder, d denotes who has the legal right to allocate the entitlement, and m is the measure of damages paid to the entitlement holder when the entitlement is allocated away from her.

Isolating e, d, and m, and then considering their interaction, allows for a somewhat more explicit understanding of contract enforcement, efficiency, and distribution. For instance, when the promisee is the entitlement holder (e), the efficient breach hypothesis implicitly assigns the allocative decision (d) to the promisor and sets damages (m) to the expectation measure. Given this setup, the marginal gains and losses associated with allocation accrue entirely to the promisor, who therefore has an incentive to allocate (i.e., to perform or not) efficiently. This structure also makes plain the efficient performance hypothesis, which assigns the entitlement (e) and the allocative decision (d) to the promisee and allows a variety of damage measures (m), from expectation to disgorgement. Observe that e, d, and m operate simply as identifiers. Part II's analysis does not focus on how, as a general matter, e, d, and m should be assigned. (18) Part III does, however, address the normative implications of entitlement assignment (e) and allocation rights (d). The categorical damage measures (m), it turns out, are not particularly relevant for the argument advanced here.

1. MEANS AND AIMS OF CONTRACT ENFORCEMENT

   This Part merges the contract remedy taxonomy originated by Fuller and Perdue (expanded by Avery Katz) (19) with the taxonomy of property rules and liability rules developed by Calabresi and Melamed (expanded by Ian Ayres). (20) The former focuses on a court's aims in terms of situating one or both parties following a breach, while the latter addresses the means available to a court to implement these aims. These means and aims combine to create a dense remedial regime.

   1. Assigning and Protecting Contractual Entitlements

      Let's begin with Calabresi and Melamed's dichotomy of how law assigns and protects legal entitlements. In a dispute between A and B, a court may assign the entitlement to either A or B. The court's choice of entitlement assignment (e) is not usually the subject of welfare analyses. (21) The assignment of e, represented by the rows in Figure 1, is typically seen as predetermined by existing legal relations, which the court is simply asked to identify without regard to efficiency or other welfare considerations. The columns in Figure show the court's choices for how to protect the entitlement: a property rule and a liability rule. Property rules protect entitlements by using the state's police powers to prohibit nonconsensual...