The secrecy interest in contract law.

• Author: Ben-Shahar, Omri

A long and distinguished line of law-and-economics articles has established that in many circumstances fully compensatory expectation damages are a desirable remedy for breach of contract because they induce both efficient performance and efficient breach.(1) The expectation measure, which seeks to put the breached-against party in the position she would have been in had the contract been performed, has, therefore, tightly been chosen as the dominant contract default rule.(2) It does a far better job of regulating breach-or-perform incentives than its leading competitors--the restitution measure, the reliance measure, and specific performance.

This Essay does not directly take issue with the economic literature demonstrating the general desirability of expectation damages. Rather, it suggests that the literature is implicitly based on the assumption that it is costless for the breached-against party to reveal the information necessary to establish the magnitude of expectation damages. It then argues that in real-world transactional contexts characterized by asymmetric information and the availability of broad pretrial discovery rights, the expectation measure may not be as desirable a remedy as the existing literature suggests.

The core intuition that this Essay develops is simple. When a breach occurs and expectation damages are sought, the expectation measure will often include lost profit. Lost profit is typically calculated on the basis of business information related to the promisee's operations, such as materials and labor costs, inventory size, availability of alternative suppliers, the identity of her downstream contracting partners (customers), and, in the case of newer businesses, her business plan. This and other information revealed during the discovery process may be information that the promisee would prefer to keep private. First, revealing the information might damage her bargaining position in future contract negotiations with this or another transactor and might lead to her having to pay a higher price in future transactions. The promisee's weakened bargaining position arises not only because the promisor will know that, in the event of breach, he will have to pay higher damages, but also, and more importantly, because he will learn the true value of performance to the promisee. Knowing the value of performance to the promisee should enable the promisor to extract a greater share of the bargaining surplus in subsequent transactions. Second, if, at the time a dispute arises, there are other executory contracts between the transactors, the promisor may be able to use the information he obtains during the pretrial discovery process to engage in profitable holdup under these other contracts. Finally, even if the promisee does not intend to transact with the breaching promisor again, the information revealed during the course of the dispute may be used by other transactors with whom the promisee has ongoing relationships, to engage in holdup, to justify demands for adequate assurances of performance, or to extract additional increments of the bargaining surplus in future negotiations.(3) The revelation of the information may also weaken her bargaining position vis-a-vis banks,(4) unions,(5) insurance companies, and secured creditors, as well as damage her competitive position in a market.(6) More generally, to the extent that the value of a firm is based on the value of the private information it possesses--whether this information takes the form of a customer list or any of a variety of forms of intellectual property--legal rules that require the revelation of this information in order to obtain a remedy for breach of contract or to enforce any other substantive legal right, may be undesirable.

Recognizing that an aggrieved party will often prefer to keep the information necessary to establish the magnitude of expectation damages private suggests that while the traditional literature on remedies has focused on the aggrieved party's interest in being made whole (her "compensatory interest"), there is another, potentially conflicting interest that needs to be taken into account, namely her desire to keep information private (her "secrecy interest"). Although the secrecy interest and the compensatory interest are often in direct conflict, they cannot be reconciled simply by elevating one over the other ex post. When the secrecy interest is sufficiently strong, the cost of revealing the underlying private information may well exceed the aggrieved party's expected recovery at trial. As a consequence, the aggrieved party may not file suit and may therefore receive no compensation. Because the existence of the promisee's secrecy interest will often be known to a promisor who has either breached or is contemplating breach, the secrecy interest may undermine the credibility of the promisee's threat to sue.(7) This in turn suggests that once the effect of the secrecy interest on the aggrieved party's incentive to sue is taken into account, it may be necessary to rethink the wisdom of fully compensatory expectation damages. In contracting contexts in which the secrecy concern is important,(8) the use of a fully compensatory expectation measure in a regime with liberal rules of civil discovery may fail to achieve the widely accepted remedial goal of full ex post compensation. It may also fail to induce efficient breach-or-perform decisions because promisors will realize that promisees with a sufficiently strong secrecy interest may not have a credible threat to sue. In addition, the availability of the expectation measure may, in some contexts, lead a promisor to breach solely in the hope that a promisee will sue and that he will be able to obtain valuable information.

This Essay develops the concept of the secrecy interest in more detail and considers how taking it into account might contribute to the debate over the desirability of several of the Code's remedial provisions, the remedial structure of the new proposed Code,(9) and aspects of existing adjudicative procedures. It argues that given the liberal approach to discovery in effect in American jurisdictions, the Code's remedial provisions are not mere default rules, but rather are quasi-mandatory rules that cannot be fully contracted around. It then suggests that the Code and the rules of civil procedure should be amended in ways that enable contracting parties to opt for damage measures and discovery procedures that do not require them to reveal private, firm-specific information. More broadly, the Essay demonstrates that there is often a hidden, secrecy-related cost to obtaining compensation, and suggests that this cost may account, in part, for businessmen's hostility to the economists' notion of efficient breach.

Part I develops the theoretical claim. It explores the tension between protecting an aggrieved party's secrecy interest and protecting her compensatory interest. After introducing the distinction between subjective damage measures that require the revelation of firm-specific information and objective damages measures that do not, it suggests that in devising optimal remedies it is essential to take into account the type of information that the remedy requires the parties to provide rather than merely the magnitude of the recovery permitted. Part II considers how taking into account the aggrieved party's secrecy interest might change the standard analysis of various Code provisions and proposed Code provisions as well as their associated Official Comments and common-law doctrines. It also considers ways in which remedial rules as well as the rules and doctrines relating to cover, mitigation, performance, and adequate assurances of performance might be restructured to strike a more desirable balance between the secrecy interest and the compensatory interest. Part III explores the implications of identifying the secrecy interest for the design of adjudicative procedures. Finally, Part IV concludes by suggesting that the Code's own stated goal of protecting the compensatory interest might be better served if the law were structured to take the secrecy interest into account.

1. THE COMPENSATORY INTEREST AND THE SECRECY INTEREST IN CONTRACT DAMAGES

   1. Introducing the Secrecy Interest

      The economic literature on damage remedies has focused primarily on two polar cases--discrete exchange between strangers where expectation damages are superior (traditional law and economics),(10) and long-term, repeat-play transactions among transactors who are perfectly constrained by reputation bonds and therefore find recourse to damages unnecessary (game theory).(11) The literature has, however, ignored an important class of transactions, exemplified by buyer-supplier relationships in nonperfectly competitive markets, where reputation is a significant, yet imperfect, constraint on transactors' behavior. In these relationships transactors either deal with one another on a repeat basis or with others in the market over an extended period of time, under numerous short-term contracts whose price and other terms are negotiated anew with some regularity.(12) Because buyers and suppliers in relationships of this sort are constantly negotiating and renegotiating their agreements, each desires to keep private the information that would reveal its reservation price--that is, the price at which each would find it desirable to walk away from the proposed transaction.(13) As a consequence, when a dispute arises, an aggrieved party may often find it desirable to seek or settle for significantly less than full compensation if doing so enables her to keep valuable information secret. The expected gain from having a stronger bargaining position in future transactions and not weakening her bargaining position vis-a-vis other executory contracts with this or other transactors often outweighs the benefits of a higher immediate monetary recovery. In some contracting...