Threatening inefficient performance of injunctions and contracts.

Author:Ayres, Ian

INTRODUCTION

Threats are often conditional promises to act inefficiently. The threatener in effect says: "I will do something that hurts you more than it helps me unless you pay me not to."(1) Threatening inefficient action often in turn produces inefficiency because either the threatener follows through on her threat, resources are squandered in negotiating to avoid the threatened behavior, or the contracting parties take overly cautious steps to avoid being threatened. Contract scholars have long understood that this problem might arise when promisors threaten to breach.(2) If contract damages are not sufficient to fully compensate a promisee for lack of performance, a promisor may threaten to breach in order to extract more favorable terms. For example, a seller may threaten to breach a supply agreement--even when it is clear that performance is efficient--solely to renegotiate a higher price. Because such renegotiations are often thought to be presumptively inefficient, the rules invalidating bad faith or opportunistic renegotiation attempt to deter promisors from making the initial threat.

A parallel problem has gone virtually unnoticed: threatening to perform. In this article, we will present two broad contexts where parties threaten inefficient performance of contractual promises or other legal duties solely to gain bargaining power in a subsequent negotiation:

  1. A potential plaintiff who is owed a duty may, at times, seek inefficient injunctive relief instead of damages merely to induce a defendant (the person owing the duty) to pay an amount higher than expected court-awarded damages.

  2. And, more perversely, a potential defendant who owes a duty to another may, at times, threaten to perform an inefficient duty merely to induce the plaintiff (the person owed the duty) to accept an amount less than expected court-awarded damages.

    When a performance of some duty becomes inefficient (in the straightforward sense that the cost of performance is greater than the benefit), we will show that one side often will desire to threaten performance merely to gain bargaining power. The impulse to threaten inefficient performance does not connote, however, an ability to make credible threats. We will discuss conditions under which such threats are credible, giving rise not only to substantial negotiation costs but also to bargaining outcomes that diverge substantially from make-whole damages.

    In the contractual context, promisees at times will inefficiently seek specific performance not because they value actual performance more than damages, but because they want to sell their court-ordered right to performance back to the promisor. These promisees represent to the court that monetary damages would be insufficient to make them whole and then--before the ink dries on the injunction--offer a price to relieve the promisor of the court-ordered duty. Judge Posner foresaw just this possibility in declining to award an injunction to a coal seller:

    With continued production uneconomical, it is unlikely that an order of specific performance, if made, would ever actually be implemented.... [B]y offering [the seller] more than contract damages ... [the buyer] could induce [the seller] to discharge the contract and release [the buyer] to buy cheaper coal.... Probably, therefore, [the seller] is seeking specific performance in order to have bargaining leverage with [the buyer], and we can think of no reason why the law should give it such leverage.(3) When promisors seek to breach what have become inefficient promises, promisees may seek specific performance merely to induce the promisors to pay more than expectation (make-whole) damages.

    To understand the incentives promisees have to seek inefficient specific performance, consider a stylized variation on the facts of Peevyhouse.(4) A miner has promised to return the topsoil on a farmer's strip-mined land to its original position. Imagine that the cost of moving the topsoil turns out to be $30,000, but that the court is expected to award only diminution-in-value damages of $10,000 if the miner fails to perform. If we also assume that the farmer's actual benefit from performance (moving the soil) is $8000, the farmer has a strategic rationale for seeking specific performance of the contract.(5) If the court awards specific performance, then the Nash bargaining solution(6) is for the miner to pay the farmer $19,000 to avoid moving the soil.(7) Even though $10,000 in damages provides more compensation than $8000 in make-whole relief, the farmer has an incentive to seek an inefficient injunction in order to increase his bargaining power. Scholars have mistakenly argued that "an injured party would not choose specific performance unless damages undercompensated the party."(8) This simple example, however, shows that plaintiff/promisees may choose specific performance even when damages would overcompensate them. Although the equal division of the bargaining surplus implied by the Nash bargaining solution (which implicitly assumes equal bargaining power) may not apply to particular contexts, under a variety of alternative bargaining-power assumptions, the farmer/promisee will threaten inefficient performance as a bargaining chip.

    Plaintiffs also seek inefficient injunctions outside of contractual settings. Indeed, the incentive to seek inefficient injunctions solely for settlement value is a possibility whenever the law gives aggrieved parties the option to seek an injunction instead of monetary damages.(9) For example, consider the classic 1895 encroachment case of Pile v. Pedrick.(10) After being misinformed by a surveyor, Pedrick built a factory wall with a foundation that extended 1 3/8 inches onto Pile's land (below the surface of the land). The court offered Pile a choice of either damages for the permanent trespass or a court order to remove the wall. Pile insisted upon the latter.

    Imagine that Pedrick's cost of removing the wall was $10,000, but the court's estimate of permanent trespass damages was only $500. If we also assume that Pile's actual benefit from performance (removing the wall) was $0, we can see Pile had a strategic rationale for seeking an injunction--even if Pile knew that tearing down the wall was inefficient. The Nash bargaining solution in the shadow of an injunction was for Pedrick to pay Pile $5000.(11) Even though performance was inefficient and damages provided more than make-whole relief, Pile had an incentive to seek an injunction in order to increase his bargaining power. As we will show more formally below, the incentive to seek inefficient injunctions is particularly strong when the likely court-awarded damages are substantially lower than the cost of performance.

    Lest our gentle reader think that the incentive of plaintiffs to seek inefficient injunctions is merely another perverse, but other-worldly, implication of game theory, consider the two common law chestnuts of Edwards v. Allouez Mining Co.(12) and Rievman v. Burlington Northern Railroad Co.(13)

    In Edwards, the defendant, in 1874, "at a cost of some sixty thousand dollars erected a stamp mill on the banks of Hill creek.(14) The operation of the mill necessitated depositing large quantities of sand on the bottom lands below. As Justice Cooley summarized:

    The year following the erection of defendant's mill, complainant purchased a piece of land through which the creek runs a short distance below the mill, and upon which the mill as operated was depositing sand. The land was not purchased for use or occupation, but as a matter of speculation, and apparently under an expectation of being able to force defendant to buy it at a large advance on the purchase price. It was offered to defendant soon after the purchase, and though no price was named, the valuation which has been put upon it by complainant and his witnesses is from three to five times what it cost him, and this perhaps gives some indication what his expectations were.(15) As Edward Yorio has noted: "[T]he peculiar facts of Edwards dramatize how equitable remedies may be used to extort overcompensatory settlements."(16) Edwards represents a strategic "coming to the nuisance" in order to extort a supercompensatory payment.

    For a more contemporary example, consider the facts of Rievman. In this case, bonds issued in 1896 were secured with realty that by 1985 was worth billions of dollars more than the outstanding principal of the bonds. The terms of the bond mortgages, however, severely inhibited the sale and development of the realty. A class of bondholders brought suit "to enjoin the [defendant] Railroad from substituting other collateral for [the realty] by which the bond mortgages [were] secured."(17) The court expressly endorsed the bondholders' right to "hold up" the defendant for an immediate "premium" payment of $35.5 million (in addition to providing substitute collateral that virtually eliminated any chance of default) by threatening specific enforcement of the collateral provisions.(18) Examples abound in which the plaintiffs seek inefficient injunctive relief in order to extract a premium above the value of actual performance.(19)

    While these previous examples concern how people who are owed a duty can have an incentive to threaten inefficient performance of injunctions, it is also possible that people who owe a duty will threaten inefficient performance merely to increase their bargaining power. People who owe performance of a duty are likely to threaten inefficient performance whenever expected damages equal or exceed the cost of performance. This can be seen in a contractual setting when a court is expected to award cost of performance damages.

    Whenever expected court-awarded damages exceed the promisee's benefit from performance, a promisor's threat to perform may induce the promisee to settle a case for less than the court award. Returning again to a stylized variation of Peevyhouse, imagine now a...

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