Remedies on and off contract

Yale Law Journal

Volumn 120, Issue 4, 2011, Pages 690-727

  Brooks, Richard R W ^a   Stremitzer, Alexander ^a  

^a YALE UNIVERSITY   (United States)

Author keywords

[No Author keywords available]

Indexed keywords

EID: 79851493332     PISSN: 00440094     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (144)

1. Ballou v. Billings, 136 Mass. 307, 309 (1884) (Holmes, J.). There are disagreements about the details and motivation behind the election, but there is a broadly shared view on the right to elect. See RESTATEMENT (THIRD) OF RESTITUTION AND UNJUST ENRICHMENT § 37 (Tentative Draft No. 3, 2004); RESTATEMENT (SECOND) OF CONTRACTS § 373 & cmt. A (1981).
2. Rescission undoes the agreement, eliminating all obligations under the contract from the time of breach going forward and backward (ex tunc or ab initio effect). When obligations are eliminated only going forward from the time of breach (ex nunc effect), avoidance, termination, and cancellation are often usefully invoked as distinct remedies. See, e.g., United Nations Convention on Contracts for the International Sale of Goods, art. 81, Apr. 11, 1980, 1489 U.N.T.S. 3 [hereinafter CISG]. Regrettably, these distinctions are sometimes conflated, leading to some confusion in the law and in legal literature. The comment to section 2-608 of the Uniform Commercial Code (UCC) ("Revocation of Acceptance in Whole or in Part") makes it clear that the term "rescission" was avoided in the Code because of concern that the term was "capable of ambiguous application... and susceptible also of confusion with cancellation." U.C.C. § 2-608 cmt. 1 (2003). Confusion remained nonetheless. See Welken v. Conley, 252 N.W.2d 311, 315 (N.D. 1977). This is due in part to the Code itself sometimes using the term "rescission" and nowhere defining what it means by that usage or explaining if it differs in application from "revocation of acceptance." For a discussion of the different legal effects of rescisson, see, for example, 2 ERNST RABEL, DAS RECHT DES WARENKAUFS: EINE RECHTSVERGLEICHENDE DARSTELLUNG § 106(1) (1958);
3. Janet O'Sullivan, Rescission as a Self-Help Remedy: A Critical Analysis, 59 CAMBRIDGE L.J. 509 (2000).
4. See RESTATEMENT (THIRD) OF RESTITUTION AND UNJUST ENRICHMENT § 36 (Tentative Draft No. 3, 2004).
5. See infra Subsection II.C.1.
6. See infra Subsection II.C.2.
7. See infra Subsection II.C.3.
8. CHARLES PHINEAS SHERMAN, ROMAN LAW IN THE MODERN WORLD: MANUAL OF ROMAN LAW ILLUSTRATED BY ANGLO-AMERICAN LAW AND THE MODERN CODES § 790 (3d Ed. 1937);
9. REINHARD ZIMMERMANN, THE LAW OF OBLIGATIONS: ROMAN FOUNDATIONS OF THE CIVILIAN TRADITION 311-37 (1990).
10. The actio redhibitoria was introduced in the early part of the second century BC. ZIMMERMANN, supra, at 311 n.113. The actio quanti minoris may have been introduced later but was no doubt available in early classical law. Id. at 318. In the course of time both actions became known as "the" aedilitian remedies and were routinely available. See id. at 325. By restitution, in this reference, we mean restoration of price. By apportionment we mean price reduction in some proportion to the value of what was received by the injured party. Price could be reduced in at least three ways: first, one might simply pay a price equivalent to the lower value of what was received (quantum meruit or quantum valebant); second, the price might be reduced by the shortfall between value expected and received, which amounts to diminution in value with an upper limit set by price; third, the ratio of value received and expected could be used to multiply (that is, deflate) price accordingly. See RABEL, supra note 2, § 99(1)(a). In practice, it has been suggested that price reduction leads to roughly the same result as expectation damages for partial breach. See JAN KROPHOLLER, STUDIENKOMMENTAR BGB § 281, ¶ 5 (9th ed. 2006) (citing the official explanations of the German government bill on the reform of the law of obligations, DEUTSCHER BUNDESTAG: DRUCKSACHEN UND PROTOKOLLE [BT] 14/6040, at 226 (Ger.)).
11. Martin Schermaier, New Law Based on Old Rules: Antecedents and Paragons of the Modern Law on Producers' Liability, in EUROPEAN PERSPECTIVES ON PRODUCERS' LIABILITY: DIRECT PRODUCERS' LIABILITY FOR NON-CONFORMITY AND THE SELLERS' RIGHT OF REDRESS 77, 80-81 (Martin Ebers, André Janssen & Olaf Meyer eds., 2009).
12. HUGO GROTIUS, DE JURE BELLI AC PACIS LIBRI TRES bk. 2, ch. 12, § VIII, at 346-47 (James Brown Scott ed., Francis W. Kelsey et al. trans., William S. Hein & Co. 1995) (1646). For an account of the influence of natural law ideas on the development of warranty law, see WALTER-JÜRGEN KLEMPT, DIE GRUNDLAGEN DER SACHMÄNGELHAFTUNG DES VERKÄUFERS IM VERNUNFTRECHT UND USUS MODERNUS 22 (1967).
13. Samuel Williston, Repudiation of Contracts, 14 HARV. L. REV. 317-326 (1901).
14. There were two strong conditions in the English common law for contract rescission, both of which were substantially weakened in America. First, the promisor's breach had to be on the order of a repudiation or abandonment of the contract, which supported the fiction that repudiation or abandonment was actually an offer by the promisor to rescind the contract, allowing the other party to accept by rescinding, too, and thereby establishing a mutuality of rescission. American courts relied little on this fiction. It "must be regarded as erroneous in principle and unfortunate in practice," argued Williston. Id. at 324. He further stated: In truth rescission is imposed in invitum [against the will of the other party] by the law at the option of the injured party, and it should be, and in general is, allowed not only for repudiation or total inability, but also for any breach of contract of so material and substantial a nature as should constitute a defence to an action brought by the party in default for a refusal to proceed with the contract. Id. at 325. In other words, breaches that would allow an injured party to terminate and seek damages would also give rise to a right to rescind. Second, promisees could not ordinarily select rescission "unless both parties [could] be reinstated in their original situation in respect of the contract." 2 WILLIAM W. STORY, A TREATISE ON THE LAW OF CONTRACTS § 977. (Lawbook Exch. 2006) (4th ed. 1856); see also Williston, supra, at 326 ("It is universally agreed that rescission is not allowable unless the party seeking to rescind can and does first restore or offer to restore anything he has received under the contract...."). While English courts demanded stern adherence to literal restitution, American courts have long been willing to devise judicially determined monetary estimates of the parties' restitution interests.
15. Critics of the modern American doctrine, like Professor Andrew Kull, worry that it undermines the stability of contracts, claiming that an unlimited right of rescission-a free choice between enforcement and avoidance as a remedy for any material breach, as proposed by the Restatement-is not a rule that contracting parties would either choose or recognize.
16. Andrew Kull, Restitution as a Remedy for Breach of Contract, 67 S. CAL. L. REV. 1465-1517 (1994) (referencing RESTATEMENT (SECOND) OF CONTRACTS (1981)).
17. See RESTATEMENT (SECOND) OF CONTRACTS § 373(1) (1981) (characterizing the right to elect rescission followed by restitution as being triggered "on a breach by non-performance that gives rise to a claim for damages for total breach or on a repudiation").
18. Andrew Kull provides a compelling account of "How the Law Was Forgotten." Andrew Kull, Rescission and Restitution, 61 BUS. LAW. 569-581 (2006) (describing the decision by Arthur Corbin, reporter for the Restatement of Contracts, to eliminate the term "rescission" from that text, a decision affirmed by Allan Farnsworth, reporter for the Restatement (Second) of Contracts). The UCC has also contributed to the concealment of rescission through the murky label "revocation of acceptance." U.C.C. § 2-608 (2003). But see id. § 2-720 (describing the effect of "cancellation" or "rescission").
19. See DOUGLAS LAYCOCK, MODERN AMERICAN REMEDIES: CASES AND MATERIALS 624 (3d ed. 2002) ("[A p]laintiff may seek rescission because of its simplicity (no need to litigate the value of anything), or because of personal preferences not reflected in market values [wheremarket value often determines expectation damages in practice],... or because she has lost confidence in [the] defendant and the transaction.").
20. See Kull, supra note 11, at 1469 ("[R]estitution as an alternative remedy for breach of contract becomes interesting chiefly in cases where the aggrieved party has made an unfavorable bargain, a contract that he has been performing (or would have been obliged to complete) at a loss.").
21. Expectation damages, v, also ordinarily exceed reliance damages, which include the price, p, and any incidental reliance, rb, made by the buyer on the contract. Hence the familiar chain of inequalities, that ex ante expectation is greater than reliance, which in turn is greater than restitution of benefits conferred to the breaching party: v < p rb p. Note that if the price has not been paid up-front this inequality would turn into v - p < rb < 0. See RESTATEMENT (SECOND) OF CONTRACTS § 344 & cmt. a (1981).
22. A Kull, supra note 11, at 1477.
23. Id. at 1499. Similarly, Mark P. Gergen sees the role of self-help remedies like "the power to refuse non-conforming performance" as helping breached-against parties "to avoid suffering a loss that damages may not adequately compensate" and lowering the amount of litigation.
24. Mark P. Gergen, A Theory of Self-Help Remedies in Contract, 89 B.U. L. REV. 1397-1399 (2009).
25. Moreover, even in cases where parties would not voluntarily bargain for such a regime, we show that the availability of rescission might still be socially desirable. See infra Subsection II.C.2.
26. Throughout this Article, we refer to sellers using feminine pronouns and buyers using masculine pronouns.
27. We assume that damages are fully compensatory and costless to enforce.
28. This is the case if the seller has some market power, which is very plausible in many markets where the seller has monopoly power with respect to her own (branded) product.
29. The equilibrium path denotes the sequence of decisions made by rational players in a game. A common criterion for such rational decisions in sequential strategic interactions (called subgame-perfect equilibrium) is that no player, taking the other player's decisions as given, could profit by making another decision (which is the definition of a Nash equilibrium). Moreover (and this is the refinement added by the concept of subgame-perfect equilibrium), no player can be fooled into reacting to incredible threats.
30. R. Selten, Reexamination of the Perfectness Concept for Equilibrium Points in Extensive Games, 4 INT'L J. GAME THEORY 25 (1975),
31. which builds off his original work, Reinhard Selten, Spieltheoretische Behandlung eines Oligopolmodells mit Nachfrageträgheit, 121 Z. GESAMTE STAATSWISSENSCHAFT 301 (1965) (Ger.).
32. Kull recognizes an ex ante incentive effect but wrongly concludes that the effect can only lead to overinvestment on the part of the seller: "Such investments, being expenditures that produce no social benefit, are inefficient by definition." Kull, supra note 11, at 1506.
33. Schermaier, supra note 8, at 79-80.
34. Although a foil for some of our claims, Andrew Kull deserves particular recognition for his thoughtful research on restitution. See, e.g., sources cited supra notes 11, 13;
35. E. Allan Farnsworth, Your Loss or My Gain? The Dilemma of the Disgorgement Principle in Breach of Contract, 94 YALE L.J. 1339 (1985) (arguing that the disgorgement principle should be extended to cover certain cases of breach of contract);
36. Daniel Friedmann, Restitution for Wrongs: The Measure of Recovery, 79 TEX. L. REV. 1879 (2001) (proposing a framework enabling a court to decide whether a party in breach of contract should have to make full restitution if her gain exceeds the other party's loss);
37. Joseph M. Perillo, Restitution in a Contractual Context, 73 COLUM. L. REV. 1208-1209 (1973)
38. Arguing that restitution should not be seen merely as a remedy in cases of quasi-contract-that is, in cases where there is no actual contract-but rather as a remedy that often operates in an explicitly contractual setting where ordinary contract enforcement is defeated because "an agreement is made but is too indefinite, a contract is made but is unenforceable because of the Statute of Frauds, a contract is made but further performance is excused because of frustration or impossibility, a contract is avoided for mistake, etc." (footnotes omitted).
39. Restricting the availability of rescission was a tendency in the drafting of the CISG. See PETER SCHLECHTRIEM, INTERNATIONALES UN-KAUFRECHT 6, 135-37 (4th ed. 2007). For a call for a more restrictive practice in the United States, see Kull, supra note 11. The law already employs several techniques to restrict rescission rights. Most importantly, it may (1) require that nonconformity exceed a certain threshold level, see CISG, supra note 2, art. 49(1)(a); COMM'N ON EUROPEAN CONTRACT LAW, PRINCIPLES OF EUROPEAN CONTRACT LAW, art. 9:301 (Ole Lando & Hugh Beale eds., 2000) [hereinafter PECL]; (2) require inspection of the goods upon delivery, see CISG, supra note 2, art. 38; (3) cut off the buyer's right to rescind if he does not notify the seller after he knew or ought to have known of the nonconformity, see id. art. 49(2)(b); and (4) require the goods to be in a condition such that restitution is possible, see id. art. 82(1); supra note 10 (describing the old common law of England).
40. The United States allows for combined remedies. See U.C.C. § 2-608 cmt. 1 (2003) ("[T]he buyer is no longer required to elect between revocation of acceptance and recovery of damages for breach. Both are now available to him."); U.C.C. § 2-711(2) (2003); LAYCOCK, supra note 14, at 638 ("With respect to contracts for the sale of goods, UCC § 2-721 provides that rescission does not bar recovery of damages; there is no exception for lost profits.");
41. GEORGE E. PALMER, THE LAW OF RESTITUTION § 4.15 (1978);
42. JOSEPH M. PERILLO, CALAMARI AND PERILLO ON CONTRACTS § 15.7 (6th ed. 2009) (citing Grandi v. LeSage, 399 P.2d 285 (N.M. 1965);
43. Robert J. Nordstrom, Restitution on Default and Article Two of the Uniform Commercial Code, 19 VAND. L. REV. 1143 (1966));
44. see also 1 PALMER, supra, § 3.9 (discussing how courts have split on whether to allow lost profits in rescission cases).
45. The trend may be observed internationally in the CISG, supra note 2, arts. 75-76; the drafts for a common European contract law, PECL, supra note 27, art. 9:305; and the revised Japanese civil code, MINPŌ [MINPŌ] [CIV. C.] art. 545, translated in Civil Code (Part I, Part II, and Part III), JAPANESE L. TRANSLATION, http://www.japaneselawtranslation.go.jp/law/ detail/?ft=3&re=02&dn=1&x=64&y=28&bu=8&ky=&p age=16 (last visited Oct. 21, 2010). The new German civil code also explicitly allows for rescission followed by expectation damages. See BÜRGERLICHES GESETZBUCH [BGB] [CIVIL CODE], Nov. 26, 2001, BUNDESGESETZBLATT, Teil I [BGBL. I] 3138, § 325, translated in Geoffrey Thomas & Gerhard Danneman, German Civil Code-Bürgerliches Gesetzbuch, IUSCOMP, http://www.iuscomp.org/gla/statutes/BGB.htm (last visited Sept. 6, 2010). Arguably, however, this did not functionally change the regime as it was also possible under the old German civil code to ask for "expectation damages in lieu of performance," which had the same effect as rescission followed by expectation. See BÜRGERLICHES GESETZBUCH [BGB] [CIVIL CODE], Aug. 18, 1896, REICHSGESETZBLATT [RGBL.] 243, § 280. There is also another force that increases the cumulative availability of rescission and expectation damages. Historically, and in civil law jurisdictions, the possibility of expectation damages (contract damages) does not arise unless the seller is at fault. In the case of nonconforming delivery, expectation damages even required deceit (dolus) on the part of the seller. The aedilitian remedies in contrast impose strict liability on the seller. Therefore, while the aedilitian remedies are available in all cases of nonconforming delivery, the problem of cumulative availability of rescission and expectation damages only arises if the seller is at fault. However, there has been a tendency over time toward relaxing the fault requirement. As the fault requirement is relaxed, expectation damages become available in more cases, and it follows that there is a risk of cumulative liability in more cases. See, e.g., ZIMMERMANN, supra note 7, at 327-28, 335-36 (discussing the famous "Pothier" rule and the German doctrine of "positive malperformance"). This problem becomes especially salient if a right of rescission is allowed at common law where the seller is strictly liable under contract law. Presumably, this was why the Uniform Sales Act, the precursor to the UCC, declared rescission and expectation damages to be mutually exclusive. UNIF. SALES ACT § 69(2) (1908). It is one of many ironies in this area that the UCC would so expressly abandon the mutual exclusivity of these remedies.
46. ZIMMERMANN, supra note 7, at 306-08.
47. Walton H. Hamilton, The Ancient Maxim Caveat Emptor, 40 YALE L.J. 1133-1157 (1931) (arguing that caveat emptor "did not embody custom or maxim, rule or philosophy").
48. ZIMMERMANN, supra note 7, at 307 & n.89 (describing the proverbs "Augen auf, Kauf ist Kauf" ("keep your eyes open, bought is bought"); "let their eye be their chapman"; and "qui n'ouvre pas yeux doit ouvrir la bourse" ("he who doesn't open his eyes shall open his purse") (translations by authors)). Note
49. id. at 311.
50. Only latent physical defects (morbus and vitium) and certain defects of character thatimpaired the "fitness for use" were covered by the aediles' edict: "Proinde si quid tale fuerit vitii sive morbi, quod usum ministeriumque hominis impediat, id dabit redhibitioni locum.'" Id. at 312 n.121 (quoting DIG. 21.1.1.8 (Ulpian, Ad Edictum 1)). J.A.C. Thomas translated Ulpian's edict as: "So if there be any defect or disease which impairs the usefulness and serviceability of the slave, that is a ground for rescission...." 1 THE DIGEST OF JUSTINIAN 21.1.1.8 (Alan Watson ed., G.E.M. de Ste Croix et al. trans., 1998). The scope of the seller's warranty, however, could be extended by formal or informal declarations (dicta promissave). Note
51. ZIMMERMANN, supra note 7, at 315-16.
52. Originally only beasts of burden other than cattle (iumenta) were covered by the edict, but the seller's liability was later generalized to all herd animals (pecus).
53. ZIMMERMANN, supra note 7, at 318-19.
54. Roman jurists invoked the good-faith (ex fide bona) clause inherent in the actio empti (the praetorian action based on the sales contract) to argue that conventional terms in express warranties became implied terms even though they were not explicitly mentioned. Id. At 320-21. Until recently it was more or less generally accepted that classical Roman law never advanced beyond the narrow scope of the edict. Although slaves and cattle were economically important goods, "caveat emptor" was still thought to prevail to a large extent. Id. at 319-20. This is also reflected in Williston's words: "It was true in both the earlier and the later classical Roman law, however, that for mere breach of a contract in regard to the goods, the buyer had no right of rescission." SAMUEL WILLISTON, THE LAW GOVERNING SALES OF GOODS AT COMMON LAW AND UNDER THE UNIFORM SALES ACT § 609 (2d ed. 1924).
55. The Corpus Iuris Civilis was issued in three parts from the years AD 529 to 534. The first part, the Codex Justinianus, compiled all imperial constitutions from the time of Hadrian. The second part, the Digests or Pandects, compiled the writings of the great Roman jurists along with current edicts. The third part, the Institutiones, was intended as a sort of legal textbook for law schools. See CHARLES M. RADDING & ANTONIO CIARALLI, THE CORPUS IURIS CIVILIS IN THE MIDDLE AGES: MANUSCRIPTS AND TRANSMISSION FROM THE SIXTH CENTURY TO THE JURISTIC REVIVAL 35 (2007). With the revival of interest in Roman law in northern Italy in the eleventh century, the Corpus Iuris was taught at the University of Bologna. Jurists and scholars trained in Roman law played a leading role in the creation of national legal systems throughout Europe.
56. See, e.g., THOMAS EDWARD SCRUTTON, THE INFLUENCE OF THE ROMAN LAW ON THE LAW OF ENGLAND: BEING THE YORKE PRIZE ESSAY OF THE UNIVERSITY OF CAMBRIDGE FOR THE YEAR 1884, at 76 (Lawbook Exch. 2010) (1885) (mentioning rescission in the context of Roman influence on English law); ZIMMERMANN, supra note 7, at ix-xi (generally describing the influence of Roman law on the early development of legal systems and jurisprudence of continental Europe and England without specific reference to the aedilitian remedies); Schermaier, supra note 8, at 80-85 (tracing the line of influence of the aedilitian remedies through the Middle Ages to modern European codifications and the English Sale of Goods Act of 1979). It is difficult to trace the influence of a specific Roman law rule on early common law. Common law was not a professorial law characterized by conceptual abstraction but rather a "jurisprudentia forensis, developing through lawyers' interpretations and judicial opinions." ZIMMERMANN, supra note 7, at xi. However, medieval common law had a striking resemblance to the aedilitian template: it allowed for acontractual action for damages for failure to perform a contractual obligation. "[I]f a condition to the whole validity of a contract failed," the plaintiff could also rescind.
57. DAVID IBBETSON, A HISTORICAL INTRODUCTION TO THE LAW OF OBLIGATIONS 223 (2001).
58. Moreover, English medieval law only recognized damages for breach of warranty if the plaintiff suffered loss from the defendant's deceit, id. at 84, similar to the dolus requirement in classic Roman law, see supra note 28.
59. The rule under which courts require the good to be fit for its ordinary purpose is referred to as the "implied warranty of merchantability." U.C.C. § 2-314 (2003). Implied warranties may also "arise from course of dealing or usage of trade." Id. § 2-314(3). Moreover, Where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller's skill or judgment to select or furnish suitable goods, there is... an implied warranty that the goods shall be fit for such purpose. Id. § 2-315.
60. Along this line, quality thresholds also trigger the on-contract remedy of rejection.
61. If, before production, the seller learns about the value of the good to the buyer, we can also interpret c as the seller's cost of production.
62. Note that the seller prefers paying compensation for total breach (segment C) over paying compensation for partial breach (segment B) whenever the value of delivery is lower than the cost of delivery (v > c). This is an instance of the well-known result that expectation damages induce "efficient breach" by the promisor.
63. RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 119-20 (7th ed. 2007);
64. Robert L. Birmingham, Damage Measures and Economic Rationality: The Geometry of Contract Law, 1969 DUKE L.J. 49;
65. Richard R.W. Brooks, The Efficient Performance Hypothesis, 116 YALE L.J. 568 (2006);
66. Charles J. Goetz & Robert E. Scott, Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach, 77 COLUM. L. REV. 554 (1977).
67. In the present context, this property holds under the plausible assumption that c > p > v̄, namely that the price is set between the variable cost to the seller and the value the buyer attaches to a good of conforming quality. It is possible to prove that the same payoffs would result if the buyer were allowed to reject a nonconforming tender.
68. Alexander Stremitzer, Standard Breach Remedies, Quality Thresholds, and Cooperative Investments, 28 J.L. ECON. & ORG. (forthcoming 2012) (manuscript at 9 & n.12), available at http://jleo.oxfordjournals.org/content/early/2010/07/28/jleo.ewq007.full .pdf+html.
69. Note that the payoff in section B can be rearranged as v - c - (v- - p) - r, which highlights that it equals the social payoff v - c - r minus a constant.
70. In our model, the socially optimal level of investment and the investment level maximizing the joint surplus of the two parties are identical.
71. A Stremitzer, supra note 40, at 12.
72. The underlying model is quite general, showing that the proven effects do not depend on the specific shape of any particular production technology. At this level of generality it is only possible to show that investment incentives strictly increase as contracting parties set the required quality level higher. Hence, the particular way in which the graph in Figure 5 is drawn only serves to illustrate that the relationship is not linear or otherwise well behaved beyond the fact that it is strictly increasing. Note
73. Aaron S. Edlin, Cadillac Contracts and Up-Front Payments: Efficient Investment Under Expectation Damages, 12 J.L. ECON. & ORG. 98 (1996).
74. CHARLES FRIED, CONTRACT AS PROMISE: A THEORY OF CONTRACTUAL OBLIGATION (1981).
75. If required quality is not explicitly specified in the contract but follows from the interpretation by courts, it is plausible to assume that courts take into account the price term in their determination of implied quality. This might distort prices upward because the buyer faces a tradeoff. He wants to increase the price in order to achieve better incentives for investments in quality that increase the joint surplus of the trading parties. At the same time, he does not want to leave too much of the surplus to the seller. The parties will therefore agree on a price that is higher than if the incentive problem did not exist but lower than what would be needed to make courts interpret implied quality to be Cadillac quality.
76. Richard R.W. Brooks & Alexander Stremitzer, On and Off Contract Remedies Inducing Cooperative Investments (Yale Law & Econ. Research Paper No. 396, 2009), available at http://ssrn.com/abstract=1524327.
77. Kull only considers the possibility of overinvestment-yet there could be underinvestment, such as if every quality level is considered to be conforming, as implicitly assumed in Yeon-Koo Che & Tai-Yeong Chung, Contract Damages and Cooperative Investments, 30 RAND J. ECON. 84(1999).
78. For a formal analysis of this point, Alexander Stremitzer, Opportunistic Termination, 28 J.L. ECON. & ORG. (forthcoming 2012), available at http://jleo.oxfordjournals.org/content/early/2010/05/21/jleo.ewq004.full .pdf+html. The effect can only occur if there is a positive chance that renegotiations are not possible.
79. OLIVER E. WILLIAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM: FIRMS, MARKETS, RELATIONAL CONTRACTING 61-67 (1985);
80. Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. POL. ECON. 691 (1986);
81. Paul A. Grout, Investment and Wages in the Absence of Binding Contracts: A Nash Bargaining Approach, 52 ECONOMETRICA 449 (1984);
82. Oliver Hart & John Moore, Incomplete Contracts and Renegotiation, 56 ECONOMETRICA 755 (1988);
83. Benjamin Klein, Robert G. Crawford & Armen A. Alchian, Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, 21 J.L. & ECON. 297 (1978);
84. Oliver E. Williamson, Transaction-Cost Economics: The Governance of Contractual Relations, 22 J.L. & ECON. 233 (1979).
85. R Brooks & A Stremitzer, supra note 47.
86. The reasoning with higher stipulated quality levels is similar but a bit more complicated to describe.
87. Note, however, that the interval in which quality is above the threshold is divided into two segments: one where trade is ex post efficient as value exceeds cost of performance (segment A) and another where trade is ex post inefficient (segment B). Therefore, although the seller's payoffs are the same in both segments, the actual allocative decisions taken by the parties are quite different. In segment A, the contract is performed, and the seller receives the agreed-upon price p but incurs cost of performance c. In segment B, the seller is willing and able to deliver goods of conforming quality, which, if accepted by the buyer, would leave the buyer with a payoff of v - p, but if rejected would constitute breach for which the buyer would have to compensate the seller with her expected profit of p - c. Because it is the case in segment B that c < v, it follows that the buyer prefers paying the seller herexpectation interest over accepting the good as -(p - c) = c - p is greater than v - p. As no rescission rights are triggered, the contract is effectively governed by expectation damages in segments A and B, which are known to induce ex-post-efficient breach by the parties. See supra note 40 and accompanying text.
88. If the quality of the proposed solution falls below threshold v̄, the buyer can elect betweenrescission and expectation damages. If he chooses rescission followed by restitution, the seller derives a payoff of zero. If the buyer opts for expectation damages, the seller has to pay the buyer his expectation interest v̄ - p whenever this expression is positive (as damage payments are truncated at zero). If parties stipulate a price that is at least as high as the cost of project implementation (p _ c), it follows that the damage payments are zero, as it can be seen from Figure 6 that the threshold value is lower than price, v̄ > p. Hence, the seller's payoff in segment C is zero minus the cost of investment, 0 - r.
89. Strictly speaking, it is also necessary to prove that the seller's expected payoff as a function of investment must be concave at this price. See Brooks & Stremitzer, supra note 47, for the formal proof that this condition holds for the price that induces the socially optimalinvestment level.
90. A similar effect can be obtained by combining the off-contract remedy of rescission followed by restitution with the on-contract remedy of specific performance. See Stremitzer, supra note 40, for a formal analysis of this effect.
91. Technically, our result implies that only price is needed; for every quality threshold there exists a price that sets efficient incentives.
92. That is the role of the price in the case where only expectation damages are available as a remedy.
93. Remember that the parties can structure the contract in a way such that the contractor gets a positive payoff if the dampers are able to reduce vibration below acceptable levels but makes the contractor lose his investment if the quality of the dampers is nonconforming and therefore allows the owner to rescind. Hence, the contract employs both carrots and sticks to achieve the desired investments in damper quality. For a case study of a real-world project in which this problem played a role, see Daniel Alterbaum et al., The Øresund Bridge: A Case Study in the Optimization of Construction Contracts (2010) (unpublished manuscript) (on file with authors).
94. In addition, there could be interesting cross-subsidization effects if the fact of a nonconformity is only discovered in the unlikely case that the insured event occurs.
95. Brian Barnes, Note, Against Insurance Rescission, 120 YALE L.J. 328 (2010).
96. Bengt Holmström, Managerial Incentive Problems: A Dynamic Perspective, 66 REV. ECON. STUD. 169 (1999) (describing the likelihood of this result in situations in which a company or an employee is unknown and young and expects huge returns from establishing a good reputation early on-not unlike the law firm summer associate described in this text).
97. George L. Priest, Breach and Remedy for the Tender of Nonconforming Goods Under the Uniform Commercial Code: An Economic Approach, 91 HARV. L. REV. 960 (1978); see also infra note 86 and accompanying text.
98. Francesco Parisi, The Harmonization of Legal Warranties in European Sales Law: An Economic Analysis, 52 AM. J. COMP. L. 403-420 (2004).
99. See, e.g., id. at 420-21; Priest, supra note 61, at 966.
100. PETER SCHLECHTRIEM & MARTIN SCHMIDT-KESSEL, SCHULDRECHT ALLGEMEINER TEIL ¶ 534 (6th ed. 2005) (translation by authors).
101. supra note 27.
102. He might still ask the seller for some little voucher to compensate him.
103. For a formal analysis of this point, A Stremitzer, supra note 48.
104. MITCHELL POLINSKY, AN INTRODUCTION TO LAW AND ECONOMICS 150 (3d ed.2003);
105. Richard Craswell, Passing On the Costs of Legal Rules: Efficiency and Distribution in Buyer-Seller Relationships, 43 STAN. L. REV. 361 (1991).
106. However, this positive effect hinges on the assumption that parties do not renegotiate once the buyer declares that he will terminate the contract-or at least that renegotiation is not possible all of the time. If renegotiation is possible, the buyer may (threaten to) return the suit but later renegotiate and keep it. This possibility allows him to extract a rent from the seller who is willing to make concessions in order to avoid ending up with a suit that has very little value to her. Anticipating this hold-up, the seller will expend inefficiently high resources in order to prevent nonconformity, which allows the buyer to terminate in the first place.
107. The most infamous example is Boomer v. Muir, 24 P.2d 570 (Cal. Dist. Ct. App. 1933), which involved a subcontractor, Boomer, who, after realizing that he was in a losing contract, brought an action of rescission followed by restitution to recover value created by his partial performance. The original contract price for Boomer's service was over $300,000, all of which had been paid except for the final $20,000. Hence, Boomer's expectation damages were $20,000, which the court disregarded when it ordered Muir to pay him $258,000 in restitution. The magnitude of such a payoff in restitution compared to damages in contract can create strong incentives for a party to search for, or even induce, a cause of rescission. For useful discussions of Boomer and other cases, see LAYCOCK, supra note 14, at 648-52;
108. Andrew Kull, Disgorgement for Breach, the "Restitution Interest," and the Restatement of Contracts, 79 TEX. L. REV. 2021-2041 n.48 (2001).
109. Evra Corp. v. Swiss Bank Corp., 673 F.2d 951 (7th Cir. 1982).
110. Id. at 952.
111. Id. at 954.
112. See Kull, supra note 11, at 1472 ("It is difficult to think of a clearer incentive to inefficiency in the contractual relation.").
113. As we mentioned, the redistribution effect hinges on the fact that renegotiation is not always possible. See supra note 48. Any cost that increases this deadweight loss-like the cost due to strategic behavior in the case of the Pandora-potentially increases this redistribution effect.
114. Alterbaum et al., supra note 58 (manuscript at 37-47).
115. We emphasize that we are referring to restitution as a source of obligation, not as a measure of damages as it is sometimes understood.
116. Restitution is also referred to as restitutio in integrum.
117. See LAYCOCK, supra note 14, at 638 ("[A] buyer may have paid shipping costs in addition to the price.... Or he may have spent money trying to repair the goods before rescinding, or the defective goods may have damaged his other property."). Laycock goes on to observe that "[c]ourts have generally allowed recovery of [such] nonduplicative damages." Id.
118. Plaintiffs who recover price in restitution, for instance, are typically entitled to interest on price for the period it sat with defendants. See, e.g., Mut. Benefit Life Ins. Co. v. JMR Elecs. Corp., 848 F.2d 30, 32 (2d Cir. 1988). Distinctions are sometimes drawn with respect to interest based on the type of breach. For example, in Tennessee Carolina Transportation, Incorporation v. Strick Corp., 196 S.E.2d 711 (N.C. 1973), Strick Corporation manufactured and delivered 150 trailers to the plaintiff, a common cargo carrier. The trailers, however, "commenced breaking in-two when in use" by the plaintiff, who sued for breach after a failed attempt by Strick to repair the defective trailers. Id. at 714. Money damages for the breach were determined, to which the trial judge added interest. Id. at 716. The North Carolina Supreme Court reversed with regard to interest, holding that the relevant state law "was intended to provide for the recovery of interest as a matter of right only where nonperformance, not defective performance, constitutes the breach of contract sued upon." Id. at 724. It would have been a different matter, the court argued, "[h]ad defendant delivered no trailers whatsoever." Id. Potentially, had price been recovered through restitution, interest payments might have been permissible.
119. When, for example, the promisee relies by paying additional sums to third parties or the gains created by the promisor's exploitation would not have been realized if the monies were kept by the promisee, reliance or disgorgement remedies will either leave the promisor worse off or leave the promisee better off than the status quo ante.
120. For example, unjust enrichment is the claimed basis for the remedy of rescission followed by restitution. See RESTATEMENT (SECOND) OF CONTRACTS § 373 cmt. a (1981) (stating that restitution as an alternative remedy for breach of contract seeks to protect the injured party's interest by preventing "the unjust enrichment of the other party"). This is, however, far from a consensus view.
121. Kull, supra note 11, at 1480-82.
122. See Boomer v. Muir, 24 P.2d 570, 577 (Cal. Dist. Ct. App. 1933); see also LAYCOCK, supra note 14, at 648-52 (presenting the competing arguments).
123. See supra note 28.
124. WILLISTON, supra note 34, § 612 ("The right of the buyer to recoup [price]... and yet to bring an action later to recover consequential damages for breach of the warranty, has been upheld in England in a leading case." (citing Mondel v. Steel, (1841) 151 Eng. Rep. 1288 (Exch.))).
125. See supra note 28 (citing U.C.C. § 2-608 cmt. 1 (2003); LAYCOCK, supra note 14, at 638).
126. See infra Section III.C for an analysis where restitution is assumed to also give rise to reliance.
127. The breach may, of course, be because the seller has delivered substantially nonconforming goods or has not delivered at all.
128. If the seller has delivered nonconforming goods and the buyer affirms the contract, the buyer keeps the goods (valued at v) and pays the contract price (p) but collects damages equal to the difference in value between contracted performance and actual performance (v̄ - v). As v - p (v̄ - v) = v̄ - p, the resulting payoff is as depicted in Figure 7.
129. In the case that the buyer has already paid up-front, he can recover the price but also has to return the nonconforming goods that the seller might have delivered to him. On balance, again, his payoff is zero.
130. The notation [v- - p]+ is a shortcut for max[v- - p, 0], which equals v- - p whenever v- - p is positive and which equals zero otherwise.
131. Note that, as the good is nonconforming, whenever the rescission right is triggered the damages payment (v- - v) the buyer receives if he affirms the contract and keeps the good is always positive.
132. This can be due to transaction costs, asymmetric information, or a dysfunctional relationship after rejection.
133. Nothing hinges on the assumption of the parties splitting the gains from renegotiation equally. Any other sharing rule would lead to the same qualitative results.
134. If v is smaller than or equal to c, the opportunity to renegotiate will not generate any extra payoff, but neither will it cause any harm-the parties just do not reverse the buyer's decision to rescind.
135. To see this, note that if c = 0, the buyer's payoff under cumulative concurrence becomes v̄ - p 0 if the buyer affirms and [v̄ - p] (1/2)v if the buyer disaffirms. (Remember that the notation [c - v] is a shortcut for max[c - v, 0], which equals c - v whenever c - v is positive and which equals zero otherwise. See supra note 91.) The latter expression is obviously greater than or equal to the former, as v _[c = 0. Under alternative concurrence, the buyer's payoff from affirming is v̄ - p, while it is (1/2)v for disaffirming. Which option leaves the buyer better off depends on the specific case at hand.
136. Affirmation under alternative concurrence occurs for v _ 2(v̄ - p) c, while under cumulative concurrence it occurs for v _ min[2(v̄ - p) c, c]. The latter condition is obviously harder to satisfy than the former. To see this, consider the case where v̄ < p.
137. This is the case if 2(v- - p) + c > c. However, as mentioned previously, redistribution cannot occur if the probability of renegotiation is one. See supra note 48.
138. For details, see Brooks & Stremitzer, supra note 47.
139. Note that the availability of the price term as a tool for efficient contracting is also behind some of the desirable properties of restoration of price as a remedy.
140. The expectation measure here is the familiar "diminution in value," sometimes called "difference in value," which grants the buyer a monetary payment equivalent to the value he would have received had performance been conforming minus the value he did receive from actual performance.
141. We treat stability of contracting as a value of its own here and do not relate it directly to welfare effects. One might, however, argue that more frequent breaching is likely to lead to higher transaction costs as more disputes arise.
142. This is not to say that, in a regime permitting rescission, contracts cannot be written that would result in overinvestment. We simply establish that for every given quality threshold, parties can find a price that counterbalances underinvestment and overinvestment incentives in such a regime.
143. The Hidden Law does not deny Our laws of probability, But takes the atom and the star And human beings as they are, And answers nothing when we lie. It is the only reason why No government can codify, And verbal definitions mar The Hidden Law.
144. W.H. AUDEN, The Hidden Law, in COLLECTED POEMS 209 (Edward Mendelson ed., 1976) (1940).