The missing elements of contract damages

Temple Law Review

Volumn 84, Issue 1, 2011, Pages 119-158

  Engler, Mitchell L ^a   Heyman, Susan B ^a,b  

^a YESHIVA UNIVERSITY   (United States)

^b ROGER WILLIAMS UNIVERSITY   (United States)

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EID: 84855460420     PISSN: 08998086     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (174)

1. 265 111. App. 542(1932).
2. 3133 N. W.2d 267 (Wis. 1965).
3. Dempsey, 265 Ill. App. at 542.
4. Tunney's victory over Dempsey in the fight then led to the famous "Long Count" rematch, "one of the most controversial prize fights in boxing history." See Michael Lamkin, Gene Tunney vs. Jack Dempsey II, FIGHT WORLD, http://www.fightbeat.com/judgejake/tunneydempsey2.php (last visited Nov. 14, 2011) (describing the rematch in detail). In the rematch, Dempsey knocked down Tunney for more than ten seconds, but nonetheless failed to get the knockout win. Id. The referee did not begin counting right upon the knockdown since Dempsey failed to follow the new neutral corner rule, which required the successful puncher to go to a neutral corner before the countdown would begin. Id.
5. Id. at 549-50. Expectancy damages seek to put the aggrieved party in the position he would have been in had the contract been performed. See. e.g., Hawkins v. McGee, 146 A. 641, 644 (N. H. 1929)
6. (citing 1 J. G. SUTHERLAND, LAW OF DAMAGES § 92 (John R. Berryman ed., 4th ed. 1916)) (holding that the aggrieved party was entitled to the difference between the value of the hand he was promised by the doctor and the value of his hand after the unsuccessful surgery). In an attempt to recover expectancy damages, the Coliseum offered proof that the boxing exhibition between Dempsey and Wills would have brought a gross receipt of $3, 000, 000 and the expenses would have been $1, 400, 000, leaving a net profit of $ 1, 600, 000.
7. Dempsey, 265 Ill. App. at 549.
8. Despite this evidence, the court found that "[t]he character of the undertaking was such that it would be impossible to produce evidence of a probative character sufficient to establish any amount which could be reasonably ascertainable." Id. Further, the two fights that did take place between Dempsey and Tunney, one in 1926 and the other in 1927, generated gate receipts of $1, 895, 000 and $2, 658, 000, respectively. JOHN P. DAWSON ET AL., CONTRACTS: CASES AND COMMENT (9th ed. 2008).
9. Dempsey, 265 Ill. App. at 552-53.
10. Damages based on the reliance interest include "expenditures made in preparation for performance or in performance." RESTATEMENT (SECOND) OF CONTRACTS § 349(1981). This provision has been interpreted to exclude precontract reliance expenditures.
11. See William Hart, Comment, The Detriment of the Bargain: How the Limiting Principle and Preclusion of Pre-Contractual Expenditures Place Undue Risk on a Non-Breaching Party, 18 REGENT U. L. REV. 349, 360(2006) (discussing that reliance damages are meant to return the plaintiff to his precontractual position). As an alternative to expectancy damages, the promoter in Dempsey sought recovery under a reliance theory for his expenditures.
12. See Dempsey, 265 Ill. App. at 552-53. The court allowed damages for special expenses incurred after the execution of the contract on March 13, 1926 (even though it was dated as of an earlier date) and before notice of repudiation on July 10, 1926, including the expenses of traveling to Colorado for Dempsey to take his physical examination, and expenses in making arrangements for publicity and accommodations. Id. at 553. However, the court denied recovery for the promotional expenditures because the coliseum entered into the contract with Andrew Weisberg for such services before Dempsey signed the contract for the prizefight, even though the Weisberg contract was executed after the date the Dempsey contract was dated (i.e., the Dempsey contract was pre-dated). Id. at 552.
13. Dempsey, 265 Ill. App. at 551.
14. See Hoffman v. Red Owl Stores, Inc., 133 N. W.2d 267 (Wis. 1965) (awarding reliance damages under the theory of promissory estoppel because Hoffman incurred substantial expenditures in reasonable reliance on Red Owl's promises and assurances of a supermarket franchise). The Red Owl case, already one of the most analyzed and studied cases, has recently received even more attention because Professor Scott was able to obtain and review the full trial transcript.
15. See Robert E. Scott, Hoffman v. Red Owl Stores and the Myth of Precontractual Reliance, 8 OHIO ST. L. J. 71, 74-85(2007) (describing the story revealed in the full trial transcript);
16. William C. Whitford & Stewart Macaulay, Hoffman v. Red Owl Stores: The Rest of the Story, 61 HASTINGS L. J. 801(2010) (describing the interview recently conducted of Hoffman).
17. Promissory estoppel is appropriate where the following conditions are met: (a) There is a promise that the promisor should reasonably expect to induce action or forbearance of a definite and substantial character on the part of the promisee; (b) the promise induces such action or forbearance; and (c) injustice can be avoided only by enforcement of the promise. RESTATEMENT (SECOND) OF CONTRACTS § 90. See infra Part II. A for a detailed discussion of promissory estoppel.
18. See 22 AM. JUR. 2D Damages § 51(2010) ("Reliance damages in breach-of-contract cases are limited to those expenses incurred after an agreement has been reached. Because reliance damages seek to measure an injured party's 'cost of reliance' on a breached contract, that party may not recover for costs incurred prior to its execution of the contract.").
19. For a brief summary of the movie, see Plot Summary for Rocky, THE INTERNET MOVIE DATABASE, http://www.imdb.com/title/tf0075148/plotsummary (last visited Nov. 14, 2011).
20. See, e.g., L. Albert & Son v. Armstrong Rubber Co., 178 F.2d 182, 189 (2d Cir. 1949).
21. See, e.g., Beefy Trail, Inc. v. Beefy King Int'l, Inc., 267 So. 2d 853, 860 (Fla. Dist. Ct. App. 1972) (Owen, J., concurring and dissenting) ("The proof that full performance would have resulted in a loss to the plaintiff is a matter of defense; there is no burden on [the aggrieved party] to prove that there would not have been any loss.")
22. B. V. v. SCM Corp., 727 F.2d 257, 264 (2d Cir. 1984) (holding that the duty to negotiate in good faith does not arise until an "agreement in principle," which is not necessarily a contract, is formed). For a discussion regarding breach of preliminary commitments
23. see generally Alan Schwartz & Robert E. Scott, Precontraclual Liability and Preliminary Agreements, 120 HARV. L. REV. 661(2007).
24. See. e.g., Hawkins v. McGee, 146 A. 641, 644 (N. H. 1929).
25. See Dempsey, 265 Ill. App. at 549-51 (denying recovery for precontract costs, including those incurred in trying to get Dempsey to sign the contract and in hiring a promoter for the prizefight). Three leading treatises also explain that contract damages are generally limited to expenses incurred after the contract is finalized and before it is breached.
26. See 22 AM. JUR. 2D Damages § 51(2010) (limiting reliance damages in breach of contract cases to "expenses incurred after an agreement has been reached");
27. E. ALLEN FARNSWORTH, FARNSWORTH ON CONTRACTS § 12. 16, at 280 (3d ed. 2004) (injured parties may not "recover costs incurred before the contract was made" (emphasis in original));
28. JOSEPH M. PERILLO, CORBIN ON CONTRACTS § 57. 6, at 261 (rev. ed. 2005) ("Expenses incurred in inducing the making of the contract are not expenses in preparation and part performance.").
29. But see Security Stove & Mfg. Co. v. American Ry. Express Co., 51 S. W.2d 572 (Mo. Ct. App. 1932) (permitting the recovery of precontractual expenditures because Security Stove knew it could call on American Railway Express's common-law duty to accept and transport the shipment with reasonable dispatch);
30. Anglia Television Ltd. v. Reed, [1971] 3 All E. R. 690 at 692 (Eng.) (holding that although breaching party would not have been liable for losses had he not entered contract, "it does not lie in his mouth to say he is not liable, when it was because of his breach that the expenditure has been wasted").
31. Dempsey, 265 Ill. App. at 551.
32. Drysdale v. Woerth, 153 F. Supp. 2d 678, 684 (E. D. Pa. 2001)
33. (quoting 22 AM. JUR. 2d Damages § 594(1988));
34. see also Autotrol Corp. v. Cont'l Water Sys. Corp., 918 F.2d 689, 695 (7th Cir. 1990) (recognizing that expenses incurred before contract execution are not recoverable, but not adjusting the jury award because the amount was nominal);
35. Energy Capital Corp. v. United States, 47 Fed. CI. 382, 426-427(2000) (denying recovery for any expenses incurred before contract formation);
36. Gruber v. S-M News Co., 126 F. Supp. 442, 446-47 (S. D. N. Y. 1954) (denying recovery for the cost of making printing plates incurred in the performance of an oral agreement to print Christmas cards but prior to execution of a final contract);
37. Moore v. Lewis, 366 N. E.2d 594, 599 n. 3 (Ill. App. Ct. 1977)
38. (citing Dempsey, 65 Ill. App. at 550-51) (denying recovery of expenditures allegedly made on a promise to issue a contract to sell a mortgage because at the time expenditures were made there was no contract on which the promisee could rely);
39. Schatzinger Consol. Realty Co. v. Stonehill, 29-39 Ohio C. C. Dec. 587, 592-93 (Cir. Ct. 1912) (denying recovery of precontract fees paid for architectural plans before a land sale contract was finalized).
40. 133 N. W.2d 267 (Wis. 1965).
41. Red Owl, 133 N. W.2d at 277.
42. (quoting Peoples Nat'l Bank of Little Rock v. Linebarger Constr. Co., 240 S. W.2d 12, 16 (Ark. 1951)).
43. See Vigoda v. Denver Urban Renewal Auth., 646 P.2d 900, 905 (Colo. 1982) (explaining that promissory estoppel encourages fair dealing in business negotiations and discourages conduct that unreasonably causes foreseeable economic loss to one party because of its reliance on a specific promise).
44. See Michael B. Metzger & Michael J. Phillips, The Emergence of Promissory Estoppel as an Independent Theory of Recovery, 35 RUTGERS L. REV. 472, 496(1983) (noting that promissory estoppel "has been used to enforce promises too indefinite or incomplete to constitute valid offers").
45. See, e.g., Cyberchron Corp. v. Calldata Sys. Dev., 47 F.3d 39, 44-45 (2d Cir. 1995) (allowing computer hardware manufacturer to recover under promissory estoppel for materials purchased in reliance on initial purchase order that was never finalized);
46. Budget Mktg., Inc. v. Centronics Corp., 927 F.2d 421, 426-27 (8th Cir. 1991) (submitting promissory estoppel theory to jury even when the letter of intent specifically denied the existence of a contract);
47. Arcadian Phosphates, Inc., v. Arcadian Corp., 884 F.2d 69, 73-74 (2d Cir. 1989) (denying summary judgment on promissory estoppel ground because the evidence suggested that the seller made a clear, unambiguous promise that the buyer detrimentally relied on);
48. Chedd-Angier Prod. Co. v. Omni Publ'ns Int'l, Ltd., 756 F.2d 930, 935-37 (1st Cir. 1985) (allowing promissory estoppel for an illusory contract);
49. Werner v. Xerox Corp., 732 F.2d 580, 582-83 (7th Cir. 1984) (adopting promissory estoppel when enforcement is necessary to avoid injustice);
50. Goodman v. Dicker, 169 F.2d 684, 685 (D. C. Cir. 1948) (permitting recovery for reliance expenditures, but not lost profits, where lease was too indefinite to be an enforceable contract);
51. Grouse v. Group Health Plan, Inc., 306 N. W.2d 114, 116 (Minn. 1981) (finding that promissory estoppel allows for recovery under an at will employment contract);
52. Neiss v. Ehlers, 899 P.2d 700, 703-07 (Or. Ct. App. 1995) (surveying case law from other jurisdictions and extending the doctrine of promissory estoppel in Oregon to apply to promises that are too indefinite or incomplete to create enforceable obligations, including agreements to agree, on the grounds that promissory estoppel focuses on the unfair harm done to the aggrieved party).
53. For a discussion of the development and trajectory of the doctrine of promissory estoppel, see generally Jay M. Feinman, Promissory Estoppel and Judicial Method, 97 HARV. L. REV. 678(1984).
54. See, e.g., Teachers Ins. & Annuity Ass'n of Am. v. Tribune Co., 670 F. Supp. 491, 497-98 (S. D. N. Y. 1987) (recognizing the ability of parties to reach a preliminary agreement that contains "open terms that remain to be negotiated");
55. see also Reprosystem, B. V. v. SCM Corp., 727 F.2d 257, 264 (2d Cir. 1984)
56. (suggesting a multifactor analysis to determine when the duty arises). Although the parties are not bound to perform under a preliminary commitment, the parties are bound to negotiate the open issues in good faith in an attempt to reach the contractual objective within the general framework. Teachers Ins. & Annuity, 670 F. Supp. at 497-98. One court referred to this theory of liability as being the "modem trend in contract law."
57. Burbach Broad. Co. of Del. v. Elkins Radio Corp., 278 F.3d 401, 409 (4th Cir. 2002);
58. see CORBIN ON CONTRACTS, supra note 30, § 57.6 (noting that there has been a growth of cases recognizing a duty to negotiate in good faith).
59. See, e.g., Lucian Ayre Bebchuk & Omri Ben-Shahar, Precontractual Reliance, 30 J. LEGAL STUD. 423, 424(2001) ("If the contract is entered into, it will stipulate how to divide the surplus that will be generated in part by the reliance investments."); (Pubitemid 33648831)
60. See, e.g., Autotrol Corp. v. Cont'l Water Sys. Corp., 918 F.2d 689, 689-95 (7th Cir. 1990) (recognizing that expenses incurred before contract execution are not recoverable, but not adjusting the jury award because the amount was nominal);
61. Energy Capital Corp. v. United States, 47 Fed. Cl. 382, 426-427(2000) (denying recovery for any expenses incurred before contract formation);
62. Gruber v. S-M News Co., 126 F. Supp. 442, 446-47 (S. D. N. Y. 1954) (denying recovery for the cost of making printing plates incurred in the performance of an oral agreement to print Christmas cards but prior to the execution of a final contract);
63. Moore v. Lewis, 366 N. E.2d 594, 599 n. 3 (Ill. App. Ct. 1977)
64. (citing Dempsey, 265 Ill. App. at 550-51) (denying recovery of expenditures allegedly made on a promise to issue a contract to sell a mortgage because at the time expenditures were made there was no contract on which the promisee could rely);
65. Schatzinger Consol. Realty Co. v. Stonehill, 29-39 Ohio C. C. Dec. 587, 592-93 (Cir. Ct. 1912) (denying recovery of precontract fees paid for architectural plans before a land sale contract was finalized).
66. See Schwartz & Scott, supra note 26, at 689 (adopting similar reasoning to understand why parties do not include liquidated reliance damages clauses in preliminary agreements). A liquidated damages clause may also be rejected if set too low, rather than too high. See RESTATEMENT (SECOND) OF CONTRACTS § 356 cmt. a (1981).
67. There is some support for finding that precontract reliance expenditures are recoverable where a breaching party had been made aware that such expenditures had been or would be incurred and breach would cause an aggrieved party to suffer damages in the amount expended. See, e.g., 22 AM. JUR. 2D Damages § 97(2010) (explaining that expenses incurred before mortgage company agreed to provide construction financing may be recoverable if bank had knowledge of those expenditures);
68. see also Westfed Holdings, Inc. v. United States, 407 F.3d 1352, 1367 (Fed. Cir. 2005) (permitting recovery of damages based on letter of intent, but denying recovery of other precontract expenditures made before the execution of the letter of intent);
69. DPJ Co. Ltd. P'ship v. FDIC, 30 F.3d 247, 249-50 (1st Cir. 1994) (permitting reimbursement for precontractual expenditures because they were incurred in trying to fulfill conditions of the commitment letter-there was a reasonable expectation at the time expenditures were incurred that the loan would be issued).
70. "An integrated agreement is a writing.... which in view of its completeness and specificity reasonably appears to be a complete agreement...." RESTATEMENT (SECOND) OF CONTRACTS § 209.
71. Id § 213. The Uniform Commercial Code (UCC), governing the sale of goods, contains a similar provision regarding parol evidence: "Terms... [in] a final expression of their agreement... may not be contradicted by evidence of any prior agreement... but may be explained or supplemented... by evidence of consistent additional terms." U. C. C. § 2-202(2004);
72. see also Patton v. Mid-Continent Sys., Inc., 841 F.2d 742, 745 (7th Cir. 1988) (ruling that the parol evidence rule limits the admissibility of evidence regarding negotiations preceding the written contract);
73. Lipsit v. Leonard, 315 A.2d 25, 29 (N. J. 1974) (holding that alleged oral promises were inadmissible under the parol evidence rule).
74. See RESTATEMENT (SECOND) OF CONTRACTS § 213, illus. 2;
75. See Robert E. Hudec, Restating the "Reliance Interest", 67 CORNELL L. REV. 704, 721(1982) (explaining that courts may adopt various time-bending constructions to justify awarding precontract expenses as reliance damages).
76. The Dempsey court emphasized that liability should only accrue after the date the agreement was consummated even if there were negotiations clearly indicating an agreement between the parties as of an earlier date. Chicago Coliseum Club v. Dempsey, 265 Ill. App. 542, 551 (Ill. Ct. App. 1932) ("The action is based upon the written agreement... any obligations assumed by the [Coliseum] prior to that time are not chargeable to [Dempsey].").
77. See Robert A. Prentice & Jonathan J. Koehler, A Normality Bias in Legal Decision Making, 88 CORNELL L. REV. 583, 604-05(2003) ("Economists widely agree that sunk costs should be ignored when deciding whether to take on additional costs." (emphasis omitted)).
78. Note that there is some overlap between these categories (i.e., fixed overhead relating to periods prior to the contract signing). Nonetheless, they are two separate categories, as precontract expenditures can include variable expenditures as well, and the fixed overhead issue can arise for periods after the contract signing. See, e.g., Autotrol Corp. v. Cont'l Water Sys. Corp., 918 F.2d 689, 692-93 (7th Cir. 1990) (distinguishing between precontract and variable expenditures, both of which are recoverable overhead costs under Texas law).
79. This statement focuses on expenditures incurred prior to the breach by the breaching party. As discussed in greater detail below, the analysis is a little more nuanced once the focus expands to include postbreach expenditures (generally recovery, then limited to only truly fixed overhead). Further, note how the aggrieved party would not recover all its expenditures where it can be shown that the contract would have generated a loss for the aggrieved party. See L. Albert & Son v. Armstrong Rubber Co., 178 F.2d 182, 189 (2d Cir. 1949) (shifting burden of proving amount promisee lost in potential future revenue had promisor not caused delay in performance of promise on promisor);
80. Cont'l Water, 918 F.2d at 694 (stating that "[t]he defendants do not deny that Autotrol would have done well enough on the contract to cover the overhead expenses allocated to it, and with that concession Autotrol's case is complete"). See also infra Part IV. B for a discussion of how, even under our proposed risky return profit theory, a breaching party may limit recovery by the non-breaching party if it can be shown that the contract would have resulted in a loss.
81. 918 F.2d 689 (7th Cir. 1990).
82. "Prebreach overhead" will be used herein to refer to overhead incurred before breach but after contract formation. Overhead incurred before both contract formation and breach is covered more generally as part of precontract expenditures. Com l' Water, 918 F.2d at 694.
83. E.g., Leingang v. City of Mandan Weed Bd., 468 N. W.2d 397, 398 (N. D. 1991) (aggrieved party entitled to the contract price less costs avoided by breach). Judge Posner's formulation also comports with an alternate, equivalent calculation equal to all expenditures incurred plus the overall profit on the contract.
84. E.g., Rockingham Cnty. v. Luten Bridge Co., 35 F.2d 301, 308 (4th Cir. 1929) (aggrieved party entitled to expenses incurred in part performance plus profits it would have earned if there was full performance). Note how incurred expenditures do not include those that could have been avoided under mitigation principles.
85. See Com'l Water, 918 F.2d at 694 (noting that since the breach occurred after the overhead expenses had been incurred, the jury would not have been entitled to subtract the overhead if there had been a set contract price). Note how mitigation generally cannot apply to prebreach overhead, as it has already been incurred at the time of breach.
86. See supra note 55 and accompanying text for a discussion of recoverable expenditures by the aggrieved party. Posner also discussed prebreach overhead in Continental Water, where because the breach occurred after the overhead was incurred the overhead expenses were not subtracted from the contract price since it was too late for the aggrieved party to make a substitute contract to cover those already incurred costs. Cont'l Water, 918 F.2d at 694. As noted earlier, such expenditures might be denied upon a satisfactory showing that the aggrieved party would have taken a loss on the contract, but that is a separate point.
87. see also L. Albert & Son v. Armstrong Rubber Co., 178 F.2d 182, 191 (2d Cir. 1949);
88. RESTATEMENT (SECOND) OF CONTRACTS § 349(1981) (explaining similar concept under current law regarding the possible reduction of expenses incurred after the contract formation).
89. Autotrol Corp. v. Cont'l Water Sys. Corp., 918 F.2d 689, 695 (7th Cir. 1990). To the extent that Judge Posner's approach would take pressure off those alternate inquiries, note how we have moved closer to our preferred regime that would allow just the sunk cost recovery without any further inquiry. Further note that although we support Judge Posner's movement towards greater recovery as a matter of bottom-line result, we do not believe that one needs to justify such movement on grounds of simplifying litigation. Rather, as discussed above, we believe it is conceptually correct to provide the recovery, and that the only issue under consideration is whether administrative concerns should override the theoretically correct movement towards allowing the recovery. From that perspective, Judge Posner's approach lends further support to our view since he seemingly supports a greater recovery of such amounts on administrative grounds apart from our theoretic arguments.
90. Cont'l Water, 918 F.2d at 692-95.
91. See, e.g., RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW § 4.10, at 119-20 (7th ed. 2007) (asserting that the promisor may break a promise for economic gain);
92. Robert L. Birmingham, Breach of Contract, Damage Measures, and Economic Efficiency, 24 RUTGERS L. REV. 273, 292(1970) (arguing that a default remedy for breach of contract that protects the expectation interest promotes economic efficiency by promoting the optimal allocation of resources);
93. Daniel A. Farber, Reassessing the Economic Efficiency of Compensatory Damages for Breach of Contract, 66 VA. L. REV. 1443, 1468(1980) (stating that economic efficiency would be promoted by the availability of supercompensatory damages).
94. A breach is considered "Pareto efficient" or "Pareto optimal" if there is "no change from that situation that can make someone better off without making someone else worse off." Mark Pettit, Jr., Private Advantage and Public Power: Reexamining the Expectation and Reliance Interests in Contract Damages, 38 HASTINGS L. J. 417, 432(1987)
95. (quoting A. M. POLINSKY, AN INTRODUCTION TO LAW AND ECONOMICS 7 n. 4(1983)). A breach is considered "Kaldor-Hicks efficient" "if and only if under the redistribution the winners win enough so that they could compensate the losers-[but] does not require that the winners actually
96. (quoting Jules Coleman, Efficiency, Exchange, and Auction: Philosophic Aspects of the Economic Approach to Law, 68 CALIF. L. REV. 221, 239(1980)).
97. This is in addition to losing out on any potential profits. Although the aggrieved party might receive some interest on its recovery, the interest rate typically is low and the interest generally starts accumulating after the time of expenditure. See infra Part IV. B for a discussion regarding the risky rate of return percentage; see also Patton v. Mid-Continent Sys., Inc., 841 F.2d 742, 751 (7th Cir. 1988) ("Not all breaches of contract are... efficient. Some are opportunistic; the promisor... exploits the inadequacies of purely compensatory remedies (the major inadequacies being that pre-and postjudgment interest rates are frequently below market levels when the risk of nonpayment is taken into account and that the winning party cannot recover his attorney fees)."). Additionally, some jurisdictions do award reasonable attorney fees.
98. See, e.g., Autotrol Corp. v. Cont'l Water Sys. Corp., 918 F.2d 689, 695 (7th Cir. 1990) (affirming that Texas does award reasonable attorney fees). A more comprehensive discussion of attorney fees is beyond the scope of this Article.
99. Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 YALE L. J. 87(1989).
100. Hadley v. Baxendale, (1854) 9 EX. 341.
101. See Richard Craswell, Contract Remedies, Renegotiation, and the Theory of Efficient Breach, 61 S. CAL. L. REV. 629, 632(1988) (discussing role of renegotiating costs in incentivizing parties to breach or perform). With this in mind, the relevance seems to be more about distribution (sharing of the pie) than efficiency (increasing the size of the pie). But see infra note 89 for a discussion on how, arguably, the default rules create efficient outcomes because the decision to breach is dependent upon the consequences of the breach.
102. As discussed in greater detail in the next Section, negotiations reversing default rules can be costly, especially where the default rules contain some uncertainty. See Patton v. Mid-Continent Sys., Inc., 841 F.2d 742, 750 (7th Cir. 1988) ("If [the breaching party] is forced to pay more than [the aggrieved party's actual losses] an efficient breach may be deterred, and the law doesn't want to bring about such a result."); Craswell, supra note 85, at 632 (stating that "the assumption of costless transactions must be relaxed").
103. See, e.g., 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, 558(1977) ("As long as the compensation [for breach] adequately mirrors the value of performance, the damage rule is 'efficient.' It induces a result superior to performance, since one party receives the same benefits as performance while the other is able to do even better.");
104. Ian R. Macneil, Efficient Breach of Contract: Circles in the Sky, 68 VA. L. REV. 947, 948(1982) ("[Epciency theory suggests that promisors who breach increase society's welfare if their benefit exceeds the losses of the promisees." (alteration in original)).
105. See Patton, 841 F.2d at 751 ("Not all breaches of contract are... efficient. Some are opportunistic; the promisor... exploits the inadequacies of purely compensatory remedies....");
106. Although it has been believed that until recently contract law did not protect the disgorgement interest, there have been periodic expressions of support for the remedy. See, e.g., Laurin v. De Carolis Constr. Co., 363 N. E.2d 675, 678-79 (Mass. 1977) (holding that purchaser of land was entitled to disgorgement of profits that contractor had derived from removing and selling trees from the property after the contract had been signed under theory of deprivation of a contract interest as opposed to a property interest);
107. John P. Dawson, Restitution or Damages?, 20 OHIO ST. L. J. 175, 186-87(1959) (stating that the established principle of equity courts in land contract cases, which allows land contract purchaser to sue a defaulting vendor in equity and recover money proceeds of vendor's wrongful resale, should be more widely employed as a contract damage remedy);
108. Melvin A. Eisenberg, The Disgorgement Interest in Contract Law, 105 MICH. L. REV. 559, 578-79(2006) (stating that since the 1950s, secondary literature periodically expressed support for the disgorgement interest based solely on the question of validity of the breaching promisor to retain his gains from breach).
109. See RESTATEMENT (THIRD) OF AGENCY § 8.05 cmt. b, illus. 4(2006) (stating that an agent who wrongfully possesses property of a principal is not entitled to recover compensation for improvements the agent makes to the property);
110. RESTATEMENT (THIRD) OF RESTITUTION AND UNJUST ENRICHMENT § 1 cmt. b, illus. 5 (Discussion Draft 2000) (providing an example of a disgorgement remedy where trespasser benefits from an intentional trespass).
111. RESTATEMENT (THIRD) OF RESTITUTION AND UNJUST ENRICHMENT § 39 (Tentative Draft No. 4, 2005) [hereinafter RESTATEMENT (THIRD) OF RESTITUTION (Tentative Draft)] ("If a breach of contract is both material and opportunistic, the injured promisee has a claim in restitutio [sic] to the profit realized by the defaulting promisor as a result of the breach. Liability in restitution with disgorgement of profit is an alternative to liability for contract damages measured by injury to the promisee.") The proposed disgorgement remedy is guided by a test of remoteness and does not necessarily require forfeiture of the entire profit. Id. cmt. f. An illustration in the proposed Restatement (Third) demonstrates the calculation of disgorgement damages. Suppose Farmer sells Buyer his entire crop of carrots for the coming season at a price of $500 per ton. Fanner's carrots have unique qualities not obtainable elsewhere. Bad weather results in reduced harvest and higher prices. Farmer delivers twenty tons of carrots to Buyer, then sells ten tons to a competing buyer at $800 per ton. Buyer is entitled to recover $3, 000 from Farmer under a disgorgement remedy. It is irrelevant that buyer's provable contract damages (measured by the contract-market differential) might be less than $3, 000. See generally id. cmt. i, illus. 15.
112. RESTATEMENT (THIRD) OF RESTITUTION (Tentative Draft) § 39(3) (b). The disgorgement section is meant to apply to situations where the promised performance has no "full equivalent" on the market (i.e., breach of a promise to maintain a confidence, to refrain from competition, or other prohibited conduct). Id. cmts. b, d. Further, it is meant to apply to opportunistic breaches, meaning a breach involving a deliberate choice by the breaching party to improve the terms of the transaction by exploiting the vulnerability of the aggrieved party whose contractual expectations may not be adequately protected by a contract remedy limited to provable damages. Id. cmt. d.
113. (quoting 1 GEORGE E. PALMER, THE LAW OF RESTITUTION §4.9, at 451(1978))).
114. See RESTATEMENT (THIRD) OF RESTITUTION (Tentative Draft) § 39 cmt c (stating that the fact that specific performance or injunctive relief might have previously been available is significant indication of propriety of disgorgement relief). As example, suppose a publisher owned the copyright of a book and prints hardcover copies. The publisher then licensed to another publisher the rights to publish the paperback edition of the book after October 1985. In breach of this agreement, the paperback publisher prematurely printed and sold paperback copies in September, and the book rose to the top of the paperback best-seller list In U. S. Naval Institute v. Charter Communications, Inc., the Second Circuit held that the aggrieved party was entitled to lost profits on the sales it would have made to purchasers who would have purchased the hardcover edition in September if the paperback version was not available.
115. U. S. Naval Inst v. Charter Commc'ns, Inc., 936 F.2d 692 (2d Cir. 1991). However, the court held that the aggrieved party was not entitled to disgorgement of the paperback publisher's profits because the general principle of contract law is that the aggrieved party's damages should be measured by the aggrieved party's losses, not the breaching party's gains. Id at 69. Supporters of the disgorgement remedy for contract interests assert that disgorgement should have been awarded because the aggrieved party would have almost certainly
116. A standard presumption of contract law is that relief should be compensatory, as the obligation imposed by contract (as compared to fiduciary obligation or tort) lies in a choice between performance and payment of damages. Accordingly, damages for breach of contract should not be dependent on the aggrieved party's state of mind-it should be irrelevant whether the breaching party breached for a good reason or a bad reason. RESTATEMENT (THIRD) OF RESTITUTION (Tentative Draft) § 39 cmt. a.
117. See Hawkins v. McGee, 146 A. 641, 643 (N. H. 1929).
118. See, e.g., Acme Mills & Elevator Co., v. Johnson, 133 S. W. 784, 785 (Ky. 1911) (holding that contract damages should be measured by the harm to the aggrieved party, rather than the gain to the breaching party).
119. For an in depth discussion of the difficulties in calculating the profits realized as a result of breach, see E. Allan Farnsworth, Your Loss or My Gain? The Dilemma of the Disgorgement Principle in Breach of Contract, 94 YALE L. J. 1339, 1350, 1370(1985).
120. RESTATEMENT (THIRD) OF RESTITUTION (Tentative Draft) § 39(3) (b).
121. See, e.g., HOWARD O. HUNTER, MODERN LAW OF CONTRACTS § 1:44(2011) (recognizing that this provision appears to be at odds with the theory of efficient breach);
122. Caprice L. Roberts, Restitutionary Disgorgement as a Moral Compass for Breach of Contract, 77 U. CM. L. REV. 991, 1009(2009) (explaining that disgorgement removes the incentives for the promisor to breach, even where such breach would increase social welfare).
123. Patton v. Mid-Continent Sys., Inc., 841 F.2d 742, 750 (7th Cir. 1988);
124. see also J. Yanan & Assoc., Inc. v. Integrity Ins. Co., 771 F.2d 1025, 1034 (7th Cir. 1985) (stating that when a contract is breached to take advantage of a more profitable alternative, compensatory damages suffice because the point of damages is to make a breach so expensive that it will only be undertaken if the benefits outweigh costs, but not so expensive that even a beneficial switch will not be undertaken).
125. The drafters of the Restatement preferred renegotiation to breach: "To take without asking, having calculated that one's anticipated liability in damages is less than the price one would have to pay to purchase the rights in question, is precisely the conduct that the law of restitution condemns." RESTATEMENT (THIRD) OF RESTITUTION (Tentative Draft) § 39 cmt. i. The idea of efficient renegotiation was explored by Judge Posner over two decades ago
126. Taylor v. Meirick, 712 F.2d 1112, 1120 (7th Cir. 1983).
127. (citing Paul G. Mahoney, Contract Remedies and Option Pricing, 24 J. LEGAL STUD. 139, 141(1995)). Several economic theorists have argued that under the Coase Theorem any remedy would be equally efficient because parties will renegotiate to reach the "Pareto efficient" results absent transaction or bargaining costs.
128. See generally R. H. Coase, The Problem of Social Cost, 3 J. L. & ECON. 1(1960) (introducing the Coase Theorem);
129. Cf. Alan Schwartz & Robert E. Scott, Contract Theory and the Limits of Contract Law, 113 YALE L. J. 541, 618(2003) (concluding that the "effective domain of state-supplied contract law" limits party options, and creates standards that, in a complex world, are often "unsatisfactory").
130. see also Juliet Kotritsky, Uncertainly, Reliance, Preliminary Negotiations and the Holdup Problem, 61 SMU L. REV. 1377, 1410-38(2008).
131. Stewart Macaulay, The Reliance Interest and the World Outside the Law Schools' Doors, 1991 WIS. L. REV. 247, 264(1991) ("Insofar as we think contracts law should reflect business expectations and reinforce a sense of security, denying any remedy for breach of uncertain obligations or limiting recovery to out-of-pocket expenses may fail to serve this purpose.").
132. see also Am. Nat'l Bank & Trust Co. of Chicago v. Reg'l Transp. Auth., 125 F.3d 420, 437 (7th Cir. 1997) (stating that "a jury has wide discretion in determining damages, as long as it has a reasonable basis"
133. (quoting Dressier Indus., Inc. v. Gradall Co., 965 F.2d 1442, 1447 (7th Cir. 1992)));
134. * 11 (N. D. Ill. 2004) (stating that "where the existence of damages is established, the evidence need only tend to show a basis for the computation of damages with a fair degree of probability"
135. (quoting To-Am Equip. Co. v. Mitsubishi Caterpillar Forklift Am., Inc., 152 F.3d 658, 664 (7th Cir. 1998)));
136. Godwin v. Ace Iron & Metal Co., 137 N. W.2d 151, 56 (Mich. 1965) (stating that the court "can not resist the conclusion that it is better to run a slight risk of giving somewhat more than actual compensation, than to adopt a rule which, under the circumstances of the case, will, in all reasonable probability, preclude the injured party from the recovery of a large proportion of the damages he has actually sustained from the injury, though the amount thus excluded can not be estimated with accuracy by a fixed and certain rule"
137. (quoting Allison v. Chandler, 11 Mich. 542, 553(1863))).
138. 242 N. W.2d 372 (Mich. 1976).
139. Fera, 242 N. W.2d at 374-76.
140. Id. at 376 (internal quotation marks omitted) (quoting Godwin, 137 N. W.2d at 156). Several years later, another court awarded lost profits for a new business that never commenced because of the breach of a lease agreement, reasoning, "it would be grossly unfair to deny [the aggrieved party] meaningful recovery for lack of a sufficient 'track record' where the [aggrieved party] has been prevented from establishing such a record by [the breaching party's] actions."
141. Chung v. Kaonohi Or. Co., 618 P.2d 283, 291 (Haw. 1980).
142. RESTATEMENT (THIRD) OF RESTITUTION (Tentative Draft) § 39(3) (b). See supra notes 98-105 and accompanying text for a discussion of the limited and uncertain application of disgorgement as a contract remedy.
143. Holt v. United Sec. Life Ins. & Trust Co., 72 A. 301, 306(1909) (stating that where profits prevented by repudiation of an agreement cannot be recovered, "expenditures fairly incurred [by the injured party] in preparation for performance or in part performance... form a proper subject for consideration, where the... expenditures [were made] in anticipation of the "advantage[s] that will come to him from completed performance").
144. F.2d 182, 189 (2d Cir. 1949) (citation omitted).
145. See, e.g., W. David Slawson, Why Expectation Damages for Breach of Contract Must Be the Norm: A Refutation of the Fuller and Perdue "Three Interests" Thesis, 81 NEB. L. REV. 839(2003) (arguing that expectancy should be the norm for awarding contract damages, while refuting the argument that awarding expectation damages generally results in the same amount of recovery as reliance damages). Our proposal is consistent with either view. In perfect markets there would be no difference between reliance and expectancy because the aggrieved party's loss in foregoing to enter another contract would be identical to the expectation value of the contract.
146. See L. L. Fuller & William R. Perdue, Jr., The Reliance Interest in Contract Damages, 46 YALE L. J. 52, 62(1936) (explaining that where reliance interest embraces a person's lost opportunity to enter similar contracts with another person, reliance and expectation interests merge);
147. see also Christopher W. Frost, Reconsidering the Reliance Interest, 44 ST. LOUIS U. L. J. 1361, 1366-68(2000) (explaining that reliance and expectancy measures begin to merge when considering lost opportunity and that, taken literally, reliance becomes indistinguishable from expectancy). Under expectancy damages, the aggrieved party would be entitled to recover lost profits plus expenses incurred prior to breach. Now, taking reliance on its own terms, the aggrieved party would be entitled to recover expenses incurred in preparation for performance, and we can include an amount close to lost profits as a proxy for lost opportunities on the use of the expenditures. The rationale for permitting recovery for lost opportunities is that the aggrieved party would have been able to allocate resources differently and probably would have been successful pursuing another profitable deal if it were not using its resources to pursue the deal with the breaching party.
148. See, e.g., Beefy Trail, Inc. v. Beefy King Int'l, Inc., 267 So. 2d 853, 860 (Dist. Ct. App. Fl. 1972) (Owen, J., concurring and dissenting) ("The proof that full performance would have resulted in a loss to the plaintiff is a matter of defense; there is no burden on [the aggrieved party] to prove that there would not have been any loss.").
149. See Macaulay, supra note 121, at 264 ("Insofar as we think contracts law should reflect business expectations and reinforce a sense of security, denying any remedy for breach of uncertain obligations or limiting recovery to out-of-pocket expenses may fail to serve this purpose."); Ofer Grosskopf & Barak Medina, Regulating Contract Formation: Precontractual Reliance, Sunk Costs and Market Structure, 39 CONN. L. REV. 1977, 1986(2007) (arguing that negotiating party may be motivated to invest in precontractual reliance through expectation of investment yields, as well as competition factors).
150. See also Vitex Mfg. Corp. v. Caribtex Corp., 377 F.2d 795, 798-99 (3d Cir. 1967) (determining that there should not be any deduction from profits where overhead is fixed and nonperformance of the contract did not produce overhead cost savings).
151. See RESTATEMENT (SECOND) OF CONTRACTS § 347(1981) (permitting recovery of expenditures incurred in preparation and part performance of the contract). See also supra Part II for a discussion of the promissory estoppel and sunk cost anomalies.
152. See 22 AM. JUR. 2d Damages § 420(2010) (explaining that the aggrieved party is generally precluded from recovering precontract costs under a reliance theory because such damages measure the aggrieved party's cost of reliance on the breached contract). See also supra note 32 for a list of cases where recovery of precontract expenditures was denied.
153. See Moore v. Lewis, 366 N. E.2d 594, 599-600 (Ill. App. Ct. 1977) (denying recovery of expenditures allegedly made on a promise to issue a contract to sell a mortgage because at the time the expenditures were made there was no contract on which the promisee could rely);
154. Am. Oil Co. v. Lovelace, 143 S. E. 293, 295 (Va. 1928) (reasoning that work done prior to the contract was done at the aggrieved party's own risk).
155. The Dempsey court reasoned: "Any obligations assumed by the plaintiff prior to [the date of the final agreement] are not chargeable to the defendant" as the plaintiff took the risk that these expenditures would be wasted if the defendant never signed the contract. Chicago Coliseum Club v. Dempsey, 265 Ill. App. 542, 551(1932).
156. See Autotrol Corp. v. Cont'l Water Sys. Corp., 918 F.2d 689 (7th Cir. 1990) (allowing manufacturer to recover a portion of its general overhead that was allocable to its performance of a joint potential venture agreement after a patent holder's breach of the agreement). See also supra Part II. A for a discussion of why damages may be higher for broken promises without a contract than with a finalized deal.
157. There has been some academic discourse advocating the expansion of damage awards for open-return contracts. Two decades ago, Michael Kelly proposed replacing the Dempsey presumption that the aggrieved party would have recouped only its postcontract costs had there been no breach with a presumption that would include recoupment of precontract costs: that is, a presumption that the aggrieved party would have broken even. Michael B. Kelly, The Phantom Reliance Interest in Contract Damages, 1992 WIS. L. REV. 1755(1992). However, this argument loses some of its force because it is not carried out far enough. As will be discussed in Part IV. B, investors do not make investments today on the expectation that they will receive back at a later point in time just the same dollar amounts.
158. See David W. Barnes, The Net Expectation Interest in Contract Damages, 48 EMORY L. J. 1137, 1206 n. 247(1999) (people enter into contracts expecting to earn more than zero profits). A few years later, Gregory Crespi advocated for recovery of documented precontract expenditures under a reliance theory of damages so long as it was within the reasonable contemplation of the parties at the time of contract formation that those expenditures would likely be wasted in the event of breach.
159. See Gregory S. Crespi, Recovering Pre-Contractual Expenditures as an Element of Reliance Damages, 49 SMU L. REV. 43, 49-50(1995). Under his reliance-based approach, expenditures would be recoverable as a proxy for lost opportunity costs postcontract Id at 50-51. Although we agree with this approach to the extent it allows recovery of precontract costs, there are several limitations. First, the proposal is premised on recovery for postcontractual foregone opportunities, which many courts reject. See Crespi, supra at 51 (noting that American courts are hostile to the recovery of precontractual expenditures). Although our proposal is not dependent on an acceptance of liability for foregone opportunities, it does fit into that concept more easily that Crespi's approach. We would permit recovery for the aggrieved parry's capital investment and return thereon based on the reasonable assumption that but for this deal, the aggrieved party would have invested in another risky deal with that expected payout Second, from an evidentiary standpoint it is difficult for the aggrieved party to prove which expenses were within the reasonable contemplation of the parties at the time of contract formation. Although we agree with a Hadley-type limitation, we propose that the limitation be used as a defense available to the breaching party rather than as an additional element for the aggrieved party to establish before setting forth a prima facie case for recovery. It appears that Crespi is proposing that the aggrieved party bear the burden of proving that the breaching party understood at the time of contracting that those expenditures would be wasted in the event of breach because he mentions that, in addition to this standard, recovery would still be subject to the "usual avoidability, foreseeability, and reasonable certainty limitations on damages." Crespi, supra at 64 (citations omitted). Finally, the proposal is limited to recovery of precontract expenditures and does not include recovery for fixed overhead or a risky rate of return on the investment (Both Kelly and Crespi's scholarship have been recognized in one of the leading contract treatises.
160. See CORBIN ON CONTRACTS, supra note 30, § 57. 3.)
161. See, e.g., DPJ Co. Ltd. P'ship v. FDIC, 30 F.3d 247, 249 (1st Cir. 1994) (permitting damages for a bank's repudiation of a line of credit in the amount of reliance expenditures, including those made after the commitment letter was issued by the bank but before the line of credit was extended, because the aggrieved party had to take steps in reliance on the commitment letter in order to meet the loan conditions).
162. See, e.g., Bebchuk & Ben-Shahar, supra note 43, at 457 (concluding that an intermediate liability approach to reliance liability is the best way to regulate precontractual investment). Ben-Shahar proposed a controversial noretraction principle that radically altered the distinction between agreement and no agreement, and could create promisor liability based on negotiations. Omri Ben-Shahar, Contracts Without Consent: Exploring a New Basis for Contractual Liability, 152 U. PA. L. REV. 1829, 1838-44(2004). In response, Johnston suggested a bargaining model to compliment the no-retraction model because promising should remain cheap early on and become more costly later in the process in order to encourage negotiations and only efficient and consented transactions.
163. Jason Scott Johnston, Investment, Information, and Promissory Liability, 152 U. PA. L. REV. 1923, 1926, 1944-46(2004).
164. Teachers Ins. & Annuity Ass'n of Am. v. Tribune Co., 670 F. Supp. 491, 499 (S. D. N. Y. 1987).
165. Hadley v. Baxendale, (1854) 9 Ex. 341, 355.
166. See RESTATEMENT (SECOND) OF CONTRACTS § 351(1981) ("Damages are not recoverable for loss that the parry in breach did not have reason to foresee as a probable result of the breach when the contract was made.").
167. Michael Crittenden & Serena Ng, Fed is Confident of AIG Payback, but Skeptics Remain, WALL ST. J., May 27, 2010, at C3 (quoting Robert Benmosche, AIG CEO, statement to Congressional Oversight Panel regarding bailout funds).
168. Our companion article, Risky Returns as Contract Damages, which is still in progress, provides a more expansive development of these points.
169. For a general discussion of the delayed provision of prejudgment interest, see Michael Knoll, A Primer on Prejudgment Interest, 75 TEX. L. REV. 293, 353-54(1996).
170. For a specific representative example, see CAL. CIV. CODE § 3287 (b) (West 2011) (providing that interest begins only on the date that the action was filed).
171. See also Kelly, supra note 147, at 1775 nn. 60-63.
172. For an example of interest beginning to accrue on the litigation commencement date, see Cyberchron Corp. v. Calldata Sys. Dev., 47 F.3d 39, 43 (2d Cir. 1995). Note that although Professor Kelly initially highlights the interest shortcomings, he then proposes only a recoupment of the expenditure without an additional profit recovery, which might explain why his proposal has not received full recognition. Kelly, supra note 147. Although running interest from a variety of different dates adds some possible complexity, the additional complexity does not seem to be problematic enough to create undercompensation, along with all the problems noted in Part II. A.
173. Consider for example the typical reluctance to bet one's savings on simple 50/50 coin toss. This relates to the diminishing marginal utility of money. See, e.g., Richard Posner, Common-Law Economic Torts: An Economic and Legal Analysis, 48 ARIZ. L. REV. 735, 738 n. 6(2006) ("Risk aversion is an implication of diminishing marginal utility of income. Most people would prefer to pay $20 to avoid a.001 probability of a $10, 000 loss than to take their chances on the loss, even though the expected cost of the loss is only $10 ($10, 000 x.001). The reason is that the expected disutility of such a loss is much greater than the expected cost because inframarginal dollars are worth more than marginal ones. It is the same reason that most people would not put up $1 million for a 50 percent chance of winning $2 million. ").
174. Regarding the breaching party showing a loss on contract, see, for example, L. Albert & Son v. Armstrong Rubber Co., 178 F.2d 182 (2d Cir. 1949).