When should an offer stick? The economics of promissory estoppel in preliminary negotiations.

• Author: Katz, Avery

Contents

1. Introduction

   1. The Regulatory Role of Contract Formation Law

   2. Promissory Estoppel and the Regulation of Reliance

2. The Legal Problem

   1. The Doctrinal Background

   2. Critique of the Traditional Approach

3. The Underlying Economic Problem

   1. The Planning Problem

   2. The Incentive Problem

   3. The Policy Problem

   1. In Specific

   2. In General

4. Extending the Regulatory Analysis

   1. Risk Aversion and Insurance

   2. Multiple Reliance Investments

   3. Two-sided Uncertainty

   4. Asymmetric and Imperfect Information

   5. Incentives to Reduce the Risk of Revocation

   6. When Courts Can Police the Efficiency of Reliance

5. Applying the Analysis to Particular Cases

   1. Determinants of Bargaining Power--A Brief Recap

   2. Relative Bargaining Power--A Selection of Examples

      1. Franchise Relationships

      2. Lender-Borrower Disputes

      3. Broker-Customer Disputes

      4. Employer-Employee Disputes

   3. Summary

6. Conclusions and Caveats

1. Introduction

   1. The Regulatory Role of Contract Formation Law

      The purpose of this Article is to examine the doctrine of promissory estoppel, as it applies in the context of preliminary negotiations, from the viewpoint of the economic theory of rational choice. This is part of a larger project that attempts to understand better the regulatory role of contract formation law generally. From a regulatory vantage point, estoppel and related legal doctrines operate as economic regulations; they shape the bargaining process by influencing the negotiators' incentives to make and to rely on preliminary communications. As with all economic regulations, however, some rules do better than others at promoting efficient exchange, and lawmakers interested in maximizing social wealth must take this into account.

      Because the regulatory perspective differs in important respects from more traditional approaches to the subject, some general remarks are necessary to set the stage. As I have argued elsewhere, the traditional literature on offer and acceptance has taken the primary functional justification for legal doctrine in the area to be coordination.(1) In this traditional view, contract formation rules are primarily social conventions that serve to help contracting parties coordinate their agreements, by ensuring that the parties attach the same meaning to their objective manifestations and that their meaning will be understood by third parties called upon to enforce the agreement. This is what Lon Fuller called the "channeling function" of legal formalities.(2)

      Courts and commentators who view contract formation law primarily as a coordination device will spend most of their time on what I have elsewhere called "convention maintenance."(3) By this I mean activities such as describing and promulgating the prevailing conventions; protecting the reliance investments of those who operate according to them; providing newcomers with incentives to learn them; and assisting everyone in applying them in ambiguous and novel situations--all for the sake of averting misunderstandings. The enterprise is primarily an interpretive one: Lawyers are directed to search for the parties' reasonable or customary expectations, given the factual circumstances of the case at hand, in order to determine what inferences the parties are justified in making about each other's intentions. As an illustration, consider the common law doctrine that, absent special circumstances, an offeree's silence in the face of an offer will not constitute assent.(4) The usual explanation for this rule is based on conventional understanding: Ordinarily, silence does not warrant an inference of consent, since there are too many other reasons to remain silent.(5)

      Within this perspective, which I will call the "coordination" or "interpretive" approach, legal analysis proceeds from the bottom up. Because the proper conventions are taken as established and as embodied in the parties' ordinary expectations, lawmaking authority is decentralized; it flows from the parties and the community from which they come to lawyers and judicial officials. Such an arrangement makes sense if parties' expectations are largely independent of legal practices--for instance, if expectations are based on social custom and are enforced by nonlegal sanctions such as reputation that the parties regard as more important than what the courts can do to them. If so, law must defer to the larger society if private individuals are not constantly to be disappointed in their endeavors. Such an approach will be familiar to students of Article 2 of the Uniform Commercial Code (UCC), which defers throughout to commercial practice and usage.(6)

      If private individuals can follow the law and adapt their expectations to it, however, an interpretive approach cannot tell us which legal rule is best. Different conventions for interpreting the parties' external manifestations are possible, and the mere requirement that law accord with expectation does not justify any legal rule in particular. Attempting to ground law in social conventions under such circumstances, therefore, is ultimately circular. This does not mean that deferring to the expectations of the regulated community is an incoherent idea, for in any particular social or historical context, the content of these expectations may be quite clear. But the justification for keeping to the prevailing conventions cannot in the end lie in the protection of expectations. As Justice Holmes famously remarked: "It is revolting to have no better reason for a rule of law than that so it was laid down in the time of Henry IV."(7) The real long-run argument for perpetuating an established convention is that there are social costs incurred in switching from one convention to another, and the costs are not worth bearing. This is why it is sometimes more important to have the law settled, and less so to have it settled correctly.

      Often, however, getting the law settled correctly is important, since the choice among conventions can affect both allocative efficiency and distributional equity. By attaching consequences to the potential acts and omissions individual bargainers might choose in a negotiation, the rules of contract formation influence the parties' incentives to behave strategically: to bluff, delay, make counteroffers, rely, and the like. The legal convention in force will accordingly influence which contracts get formed and the terms on which they get formed, and this is a matter of both private and social concern.(8)

      The traditional dominance of the interpretive approach has meant the relative neglect of such policy considerations. In order to take account of them properly, an alternative approach is necessary--one that emphasizes how the law of contract formation works to regulate behavior in negotiation. To illustrate the difference, consider how the rule governing silent acceptance looks from a regulatory perspective. Since responding to offers is costly, the common law rule requiring an affirmative response raises the expense of forming an agreement. A negative-option rule requiring the recipient to respond in order to avoid entering a contract, conversely, would make it more costly to reject offers and would increase the number of exchanges. If the chance of an acceptance were high enough, the negative-option rule would economize on the costs of sending communications, and would hence be a more efficient convention.(9)

      From the regulatory perspective, the direction of analysis is top-down rather than bottom-up. The central question is not which legal rule is consistent with the parties' expectations, but what expectations the parties should be encouraged to have in the first place. A regulatory approach to contract formation is inappropriate if parties do not or will not respond to legal sanctions. But when new contract formation rules are introduced, when old ones are overhauled, or when ambiguous ones are clarified, regulatory issues are unavoidable. In such circumstances, any decision will generate new expectational conventions, not all of which have equal social value.

      Furthermore, taking a regulatory perspective is especially important for private individuals, who often have the power to choose which conventions to use even when the state does not. In our common law system, the majority of contract formation rules are default rules rather than mandatory ones. This fact is sometimes expressed in the maxim that the offeror is "master of the offer"--that is, the offeror, by specifying what is to count as a proper acceptance, may propose changes in the rules of offer and acceptance as well as in the parties' substantive obligations.(10) A similar power is explicitly granted to parties to contracts governed by the UCC.(11) For contracting parties to use this regulatory power effectively, however, they must understand the incentives they create for themselves in doing so.

   2. Promissory Estoppel and the Regulation of Reliance

      A regulatory perspective is useful in analyzing many of the rules of contract formation, but one doctrine it particularly helps illuminate is promissory estoppel. The classic statement of this principle is found in section 90 of the Restatement (Second) of Contracts:

      A promise which the promisor should reasonably expect to induce action or forbearance on the part of the promisee or a third person and which does induce such action or forbearance is binding if injustice can be avoided only by enforcement of the promise. The remedy granted for breach may be limited as justice requires.(12)

      The doctrine of promissory estoppel is commonly explained as promoting the same purposes as the tort of misrepresentation: punishing or deterring those who mislead others to their detriment and compensating those who are misled.(13) But these purposes, and the black letter definition of section 90 itself, can be read from either an interpretive or a regulatory perspective. From the interpretive perspective, reliance is reasonable if it is customarily...