Friday, August 21, 2009

Why do we enforce contracts?

Over the course of my professional career, "Law and Economics" has grown from being one theoretical approach to law among many to one so dominant that many of its postulates have become virtually unquestioned premises in legal analysis. The Law and Economics school of thought is wide-ranging, but might fairly be described the way Wikipedia puts it: Law and Economics is an “approach to legal theory that applies methods of economics to law. It includes the use of economic concepts to explain the effects of laws, to assess which legal rules are economically efficient, and to predict which legal rules will be promulgated.”

One of the most influential premises of Law and Economics is that contractual promises are enforced purely because they maximize the society-wide allocation of resources. This view also presumes there is no moral value to a contractual promise over and above the economic value its performance would have provided. Legendarily, Oliver Wendell Holmes expressed this purely pecuniary approach to contract law has long been the approach of the common law when he wrote in the late 19th Century that “the duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it, and nothing else.” In other words, the thinking goes, if someone who has made a contractual promise can make out better by breaking the promise, paying damages for breach, and entering another deal, that result is not merely tolerable — it is desirable. Such a breach of contract is called an “efficient breach” because it theoretically results in an increase in overall resources: the party injured by the breach supposedly receives everything he was supposed to get under breached contract, the breaching party is getting something better than he would have under the contract he chose to breach, and the new party with whom the breaching party contracts is getting a deal he would not otherwise have gotten. Thus, more value exists after the breach than before.

The Law and Economics view is by no means the only current theory about why we enforce contractual promises (and the interpretation Law and Economics devotees put on Holmes’ statement is disputed by weighty authority). As a contracts professor and litigator, though, my experience is that the idea that the contract promise has no moral value over and above its economic value is a very, very influential one. It is a view, too, that is of a piece with the rise over the last thirty years to virtual unquestioned dogma that unregulated free markets always produce the highest social good.

One problem, though, is that unregulated free markets entrench the power of the wealthiest. So a wealthy party bound by a promise (the “promisor”) can as a practical matter force a change in the promise on a less affluent person to whom the promised was made (the “promisee”). The disparity in economic power the theory of efficient breach does not account for is on display in the power corporations hold to renegotiate employment contracts. Since an employee can only recover for breach whatever damages are available to him through a lawsuit (which poses risks and costs money), the threat of being limited to that legal remedy is powerful. Thus, as the New York Times pointed out last April,

Contracts everywhere are under assault.The depth of the recession and the use of taxpayer dollars to bail out companies have made it politically acceptable for overseers to tinker with employment agreements.
But, as David Skeel, a law professor from the University of Pennsylvania quoted in the article points out,
We run roughshod over some contracts and not over others. . . . Right now, employment contracts seem to be the type of contract that is viewed as eminently rewritable.
So we have Larry Summers, President Obama’s Chief Economic Adviser,
arguing in connection with huge bonuses paid to AIG employees that the promises to pay those bonuses are too sacred to undo: "We are a country of law. . . There are contracts. The government cannot just abrogate contracts. Every legal step possible to limit those bonuses is being taken by Secretary Geithner and by the Federal Reserve system.” On the other hand,the UAW’s agreement to give up rights under its contract with the auto companies was required by the government as a condition of the federal monies the automakers received.

So, are contractual promises “sacred” in some way, or are they only worth whatever the parties to them can extract given their relative power (much of which is accounted for by wealth and political influence)? I don’t think there's any single answer to this question, but one should not lose sight of the fact that something considered sacred in some situations is not considered sacred in others.


  1. Labor contracts are only worth what each party can do to enforce them. It's extreme, but the ability for a union to "burn down the damned building" turns into the only card it can play at times (especially if you spend time working under the Railway Labor Act). While that kind of leverage is immense, it does little for the union members to burn the company to the ground (in the form of a strike) only to have no job to come back to. The fact that labor unions are at times required to turn to brinkmanship to defend their labor contracts reduces their leverage in almost all situations and you get the above mentioned result of the UAW being forced to accept concessions at the hands of a bankruptcy judge (who is in this situation guided by the federal government). Unless a union is willing to put a company out of business, and it has decided that such a solution would end in a better result for its membership (not likely), a unions leverage is hampered. That's a tough place to be in.

    So it would almost have to seem that contractual promises, at least in the form of labor contracts, are only worth how much power you have to enforce them.

  2. Mr. Herreshoff -- you are way ahead of the game. Though the point is really beyond the strict scope of 1L Contracts (you'll address it much more directly in the second semester in Core Concepts), understanding your client's power is just as fundamental to effective lawyering as is knowing the law. As we always say here at UDM, there is no meaningful distinction in law between theory and practice.

  3. John Vasiloff8/25/09, 8:04 PM

    I would not really consider the UAW to be without power and influence though. Why wouldn't the same legal remedies be available to them? They aren't too poor to finance a lawyer. I know it certainly does not help that in a situation like this the UAW is under heavy pressure from the average member of the population for being too greedy in their contract stipulations, but the same applied to those executive bonuses. Were these just inconsistent choices by the federal government or was it just the fact that the AIG executive bonuses involved money concentrated in the possession of a small number of people rather than distributed to hundreds of thousands like it was with the auto industry? Maybe they anticipated much more complaint when contractually promised millions were denied to individuals rather than spread out among a large group.

  4. Mr. Vasiloff: (1) the UAW does not have nearly the political clout the financial industry does. 40 years ago that balance of power was quite different. (2) The auto companies were allowed to use the bankruptcy process, which gives a reorganizing entity the power to modify or even cancel existing contracts. Thus, the UAW was left with whatever it could extract from the companies. After September 15, 2008, the day Lehman Bros. filed for bankruptcy protection, the world went into a financial panic which, as a practical matter, meant that no other financial company was going to be allowed to go into bankruptcy. (On 9/15/08, the Wall Street Journal wrote "We are getting a Category 5 test of our financial levees.") Thus, AIG never had the legal right Chrysler and GM did -- it couldn't cancel its contractual promises. That everyone making the decisions happened to come from the financial industry didn't hurt either.

  5. 1. I would say that when a majority of your union stands to lose their jobs and therefore disassociate with the union, drastic measures had to be taken in order to keep at least the political clout they still maintained presently.

    2. I'm glad Lehman Brothers was brought up in this thread. Bear Stearns had it's "shotgun wedding" in order to preserve the insured toxic assets (not known to be toxic at the time) that was carried by other financial institutions that insured Bear Stearns' assets. Sometimes this is called a credit default swap.

    Lehman Brothers future, on the other hand, after much debate about government intervention was left to the fate of the market. This lead to the financial meltdown because other institutions that had insured Lehman Bros assets, didn't have the capital reserves to pay out the claims and were in danger of becoming bankrupt themselves, which would also cause other institutions to run out of capital because they all insured each other (the domino effect).

    So the legal question I pose is that if those credit default swaps were ordered to be void so that no payouts were made on behalf of Lehman's toxic assets, what kind of impact would that have on all the other financial institutions with agreements to insure each other? Would premiums have to be returned and would that be more catastrophic then paying out the claims on the insured?

    A hard decision to make indeed