The questionable ascent of Hadley v. Baxendale.

• Author: Adler, Barry E.

The venerable case of Hadley v. Baxendale serves as the prototype for default rules designed to penalize, and thus encourage disclosure by, an undesirable contractual counterpart. Penalty-default analysis is now widely accepted as a plausible approach to the issues presented by incomplete contracts. The ambition of this article is to challenge and refine the accepted wisdom. The article demonstrates that the structure of penalty-default theory as derived from Hadley rests on a faulty implicit premise. The premise is that damages from breach of contract are certain. In fact, damages are stochastic, Consequently, the standard penalty-default model of Hadley overlooks the potential incentive of a party to conceal information even though the party is subject to a penalty-default rule. This incentive, which is shown to exist in other contexts, may greatly complicate the evaluation of a default rule's efficacy. Thus, a lawmaker may have reason to be skeptical of her ability to identify an efficient penalty-default rule, the seeming simplicity of Hadley notwithstanding.

INTRODUCTION

At the center of contract theory is the role of default roles. Contracts are necessarily incomplete and therefore a court or legislature must fill gaps. Recent scholarship has recommended that a lawmaker charged with this task look beyond the individual parties to a contract. This scholarship suggests that a default role can be designed to induce an equilibrium at which parties of one type accept the default role while parties of another type, to whom the role is costly, opt for an alternative contract term and thus reveal their type. When such a role works as intended, the revealed information permits efficient contractual arrangements and enhances social welfare. Explained this way, as an abstraction, the analysis seems simple and sound. The devil, though, is in the details. A default rule might fail at separation for reasons that have so far escaped scholars. The analysis of default rules thus requires amendment.

A thorough analysis of default rules designed to induce separation begins with an exemplar, the widely read Hadley v. Baxendale.(1) The case is best known for the rule that bears its name:

Where two parties have made a contract which one of them has broken, the damages which the other party ought to receive in respect of such breach of contract should be such as may fairly and reasonably be considered either arising naturally, i.e., according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it.(2) Recently, this venerable rule has taken on a new aspect. Economic analysts have recognized that the limitation on damages inherent in the Hadley rule is merely a default position. A party who will suffer exceptional damages from breach need only communicate her situation in advance and gain assent to allowance so that the damages are unmistakably "in the contemplation of both parties" at the time of contract. The economic question, then, is not whether a damages limitation is inherently sensible but whether a rational rule would impose the burden of contracting for exceptional damages on those who wish to avoid the limitation. Abundant contract scholarship supplies an explanation of why one might answer this question with a yes.(3) The idea is that the party who bears special risks from breach should identify those risks so that the party with whom she contracts is on notice to take the proper precautions wherever necessary. The alternative--broad insurance for all unless such insurance is disclaimed--would waste contracting costs for disclaimer in the ordinary case or, absent disclaimer, would yield inefficient precautions taken to avoid indiscernible risks.

From Hadley's apparent lesson of efficient precautions, "penalty-default" theory has been drawn.(4) A penalty default is a rule intended to encourage opt-out by a party with private information that she will disclose when contracting for an alternative to the rule. In Hadley, a party who will suffer exceptional loss from breach is denied damages for such loss if her contract is silent. She can avoid the default rule by proposing that the contract include insurance against exceptional loss. With this proposal, she identifies herself as someone at risk of such loss and permits her counterpart to take, and charge for, efficient precaution. Penalty-default theory abstracts from the damages term at issue in Hadley. In principle, the theory may explain or justify any rule that is particularly costly for a party with private information she would like to conceal. Such a default rule may force the disclosure of information that will yield efficient contractual relationships, such as efficient precaution in Hadley.

Possible topics for penalty-default rules, suggested by scholars, range from simple terms, such as a provision controlling the method of contract acceptance, to more complex terms, such as a provision that determines a fiduciary's duty of disclosure.(5) The potential use of a penalty-default rule is not limited to the revelation of information about the party induced to reject the default term. For example, a penalty-default rule might encourage a party knowledgeable about legal rules to explicitly opt out of the default and thus inform her potentially ignorant counterpart of the term that will govern their contract.(6) Separation of parties by type, then, is not the only objective of penalty-default theory. It will, however, occupy virtually the entire analysis here.

Penalty-default theory represents a departure from traditional contract theory, which instructs a lawmaker to fill any gap in a contract with the term fully informed parties would have adopted explicitly had they addressed the contingency in question.(7) The objective of such instruction is to save the parties the cost of explicit agreement.(8) Penalty-default theory offers that a potentially more important objective can be the disclosure of information by a party who has anticipated the disputed contingency. Thus, penalty-default theory can support the rule in Hadley, for example, even if a party at risk of exceptional loss in that case would not contract for that rule's limitation on liability.

There is no question that a penalty-default rule can, in principle, be an optimal rule. Thus, there is no question that penalty-default theory represents an advance beyond traditional theory.(9) There is question, however, about the scope of this advance, which this article narrows. Others have identified limitations on the efficacy of penalty-default rules. The literature notes potential inefficiency from acceptance of such a rule by those who face high contracting costs,(10) from rejection of the rule by those who spend too much on explicit contracting,(11) and from acceptance of the rule by those who possess private information but lack the market power to prevent exploitation of that information by others.(12) Yet, it will be shown here that these qualifications do not go far enough. Even as qualified, the models of Hadley in prior work are inaccurate in a way that tends to overstate the potential efficacy of a penalty-default rule.

As typically modeled, the Hadley default rule serves to distinguish two contractual types who differ in a single respect. In the model, the common type places a low value on contract performance and will, therefore, suffer low damages in the event of default. The exceptional type places a high value on performance and will, therefore, suffer high damages in the event of default. Under a rule of expansive liability, conditions can exist such that the high-value type will conceal her true nature, pay a price for performance that would be appropriate to an average party, and then collect the full level of damages should her counterpart breach. Under the limited-liability default rule of Hadley, in contrast, the high-value type loses every incentive to be confused with the low-value type, as she can never collect the full measure of damages. Therefore, in this standard model, unless the high-value type fears exploitation from the party with whom she contracts, she has an incentive to defect from the default rule so that she may seek extra protection for her interests in the contract. If the transaction costs of such defection are sufficiently low, defection will occur and will be efficient. Thus, under the assumptions of the standard model, one might easily conclude that a penalty-default rule enhances social welfare.

The assumptions of the standard model, however, are not particularly rich. Consider the rule in Hadley under the realistic assumption that value, and thus damages, are not certain but stochastic. If damages are stochastic, a high-value type can be described not as a party who will suffer high damages in the event of breach but as one who is highly likely to suffer damages in the event of breach. More precisely, a high-value type might be described as a party more likely than a low-value type to suffer at least any specified level of damages. Under these circumstances, a high-value type could decline to contract explicitly for expansive liability, however low the transaction costs. Such defection from a limited-liability default would induce her counterpart to charge not only for the higher level of anticipated liability, as is assumed in the standard Hadley model, but for the higher probability of even ordinary liability. The charge would not be the product of market power but would reflect the revealed actual cost of efficient service and expected liability. A high-value type can avoid the full cost of service and expected liability if she accepts the default rule and remains indistinguishable from the low-value type. The high-value type will weigh the expected cost against the...