Contracts Final Exam Review Sheet I. 4 Core Requirements for an Enforceable Contract 1) Offer - A promise to do or refrain from doing something in the future conditioned on the parties acceptance 2) Acceptance - The offeree‟s voluntary exercise of power created by the rule. 3) Consideration – i. The promisee must provide a return promise or full performance ii. The promisee‟s promise or full performance must result in a legal benefit to the promisor or legal detriment to the promisee iii. The promise must induce the return or full performance; they must be made in exchange for each other (a bargained for exchange). 4) Sufficient Definiteness - If a contract is not reasonably certain as to its material terms, it may be found to be fatally indefinite and not enforceable. II. Offer and Acceptance: Elements Explained A. What Constitutes an Offer and What Constitutes an Acceptance? Bilateral - accept by any reasonable means Unilateral - accept by full performance B. Retraction of Offers Terminate by: 1) Revocation offers are revocable any time before acceptance; 2) Expiration if no date set it is within a reasonable amount of time; and 3) Rejection C. Expiration of Offers When no date is set, offer expires in a reasonable amount of time. D. Option Contracts An offer to keep an offer open; must be bound with consideration. a. Promise not to revoke b. Return promise or performance E. Advertisements An advertisement is an offer when it is “clear, definite, and explicit, and leaves nothing open for negotiation.” F. Arbitration Clauses Standard form contracts offered to consumers on a: “Take it or leave it” basis; Consumer not provided a realistic opportunity to bargain; and Consumer has no realistic choice as to its terms. General Rule: Terms of contracts of adhesion are generally enforceable Possible Exceptions (Courts Discretion): Reasonable Expectations Test: Terms beyond the range of reasonable expectations of party (objective standard) are not enforceable. [1. Unequal bargaining power; and 2. Clause does not fall within reasonable expectations of weaker party] § 211 of the Restatement 2 nd : “Where the other party has reason to believe that the party manifesting such assent would not do so if he knew that the writing contained a particular term, the term is not part of the agreement.” Unconscionability: Term may be found to be unconscionable (procedural + substantive) G. Modes of Acceptance According to the Restatement (Second) of Contracts an acceptance can manifest in several ways: “Affirmative answer in words, performing or refraining from performing a specific act(s), other actions or words, promising to perform or actually performing, etc.” H. Mirror Image Rule Acceptance must meet the mirror image rule (must mirror the terms of the offer) I. Unilateral v. Bilateral Contracts a) How do you accept a unilateral contract? Full performance b) How do you accept a bilateral contract? Accept by any reasonable means c) Implied promise not to revoke unilateral contracts The offer creates an implied promise not to revoke that is acceptance and bound with consideration by part performance. I. Consideration: Element Explained A. 4 Ways to Bind a Promise a) Consideration – 1. The promisee must provide a return promise or full performance; 2. The promisee‟s promise or full performance must result in a legal benefit to the promisor or legal detriment to the promisee; 3. The promise must induce the return or full performance; they must be made in exchange for each other (a bargained for exchange). b) Promissory Estoppel (Replacement for Consideration) – 1. A promise; 2. Promisor shall reasonably expect action/forbearance from the promisee (expect a change in behavior); 3. Promise does induce such action/forbearance; and 4. Injustice can be avoided only by enforcement of promise c) Moral Obligations (including Material Benefit Rule) As a general rule, past consideration/moral obligation is not valid consideration Material Benefit Rule – There are, however, a few categories of cases that accept past consideration/moral obligation as valid to bind a promise. Section 86 of the Restatement 2 nd provides that a promise will be binding if five elements are satisfied: 1. 2. 3. 4. 5. A promise Made in recognition of a prior benefit The prior benefit was not a gift Enforcement of the promise is necessary to prevent injustice Promise is not disproportionate to benefit d) Seals – have little bearing in today‟s society. B. Consideration and the Employment Contract (Employee Manuals) Should include a disclaimer that it‟s not an offer The disclaimer should be clear and should state that the at-will employment may not be modified except in writing by the CEO or other company officer. For an employment manual to be deemed a binding unilateral contract, the plaintiff/employee must demonstrate three elements: 1. The employment manual (or a portion thereof) constituted an offer to the employee (e.g., “the employer manifested (language) his willingness to enter into a bargain in such a way as to justify the employee in understanding that his assent to the bargain was invited by the employer and that the employee‟s assent would conclude the bargain”); 2. The employee accepted the offer; and 3. The employer‟s promise was bound by consideration. C. Contract Modifications – Pre-Existing Duty Rule v. UCC Pre-Existing Duty Rule precludes changing contract one sided without some new consideration. You can‟t “change” contract to do something you already have a duty to do. UCC Section 2-209 provides: (1) An agreement modifying a contract within this Article needs no consideration to be binding. This change from the common law of contracts supports the common business practice of adjusting the terms of agreements as conditions change. The ability to modify a sales agreement is limited by the general U.C.C. requirement of good faith.” D. Mistaken Contractor Bid Issues The Subcontractor‟s bid is temporarily irrevocable commencing when the General Contractor submits its general bid (which is based on the Subcontractor‟s bid) and continuing for the reasonable time necessary for the General Contractor (after being awarded the general contract) to accept the Subcontractor‟s bid. The Subcontractor‟s bid may still be revocable if: (1) the Subcontractor expressly stated on its bid that it was revocable; (2) the General Contractor shops the Subcontractor‟s bid to try to get a better deal; or (3) the General Contractor unreasonably delays in accepting the Subcontractor‟s bid. [Drennan] Subcontractor can revoke if: 1. the Subcontractor expressly stated on its bid that it was revocable – in such a case, there is no implied promise to bind. 2. the General Contractor shops the Subcontractor‟s bid to try to get a better deal – this negates the requirement under promissory estoppel that “injustice can be avoided only by enforcement of the promise”. Since the General Contractor is looking elsewhere, it is not unjust to allow the Subcontractor to wish to leave the deal as well. 3. the General Contractor unreasonably delays in accepting the Subcontractor‟s bid – going back to basic offer and acceptance analysis, offers will expire after a reasonable time. In this scenario, a reasonable time has passed. II. Sufficient Definiteness: Element Explained A. Contractual Gap Filling At-will employment When a contract is silent as to a material term gap filler can be used: Reasonable term may be inserted Custom and practice may fill the gap If no duration specified = reasonable time or “at-will” B. Indefiniteness If an agreement is not reasonably certain as to its material terms, it may be found to be fatally indefinite and therefore not enforceable. 3 Basic Categories of Indefinite Contracts: 1. Silent as to a material term 2. Parties purport to agree, but have left a material term indefinite Example = If you provide this service, I will pay you “a fair profit” Traditional Rule = Indefinite A material term that might appear to be indefinite may prove to be sufficiently definite through reference to: - Custom and practice - Subsequent conduct of the parties - Subsequent clarification by the parties 3. Parties agree to agree Traditional Rule = Indefinite Alternative View = May not be indefinite See the Walker and Schmeider cases for examples of how courts treat this issue I. Additional Doctrines Affecting the Enforceability of Contracts A. Capacity of Parties Contracts with Infants - Under basic common law principles, infants have an absolute right to disaffirm a contract unless otherwise provided by statute. Except: Necessaries: The common law provides that infants are liable for the reasonable value of necessaries received under a contract prior to its disaffirmation. “[T]he phrase necessaries, does not possess a fixed interpretation, but must be measured against both the infant‟s standard of living, and the ability and willingness of his guardian, if he has one, to supply the needed services or articles.” The Benefit Rule extends the common law rule to provide that infants are liable for the reasonable value of any benefit received under the contract prior to disaffirmation. Equitable Argument: the court exercises its equitable powers to achieve a just result. Contracts with Someone who is Mental Incapacitated (1) A person incurs only voidable contractual duties by entering into a transaction if by reason of mental illness or defect: (a) he is unable to understand in a reasonable manner the nature and consequences of the transaction, or (capacity) (b) he is unable to act in a reasonable manner in relation to the transaction and the other party has reason to know of his condition (compulsion). (2) Where the contract is made on fair terms and the other party is without knowledge of the mental illness or defect, the power of avoidance under Subsection (1) terminates to the extent that the contract has been so performed in whole or in part or the circumstances have so changed that avoidance would be unjust. In such a case a court may grant relief as justice requires. B. Subject Matter Illegal Bargains - “Illegal” contracts are loosely defined as contracts whose formation or performance is criminal, tortious or against public policy. As a general rule, an illegal contract is void, which means that neither party may enforce the contract. Instead, the court will leave the parties where it finds them. If the contract is found to be illegal, the general rule would be that the contract is void. However, under Restatement (Second), Section 182, if the promisee in an illegal contract “has substantially performed, enforcement of a promise is not precluded on grounds of public policy because of some improper use that the promisor intends to make of what he obtains unless the promise: acted for the purpose of furthering the improper use, or knew of the use and the use involves grave social harm.” C. Misconduct or Mistake Duress - “If a party's manifestation of assent is induced by an improper threat by the other party that leaves the victim no reasonable alternative, the contract is voidable by the victim.” The Restatement (Second) of Contracts recognizes three types of duress: duress by physical compulsion, undue influence and duress by threat. Misrepresentation – Cole Lakes provides a six-prong test for tortious misrepresentation: 1. Knowing; 2. Misrepresentation; 3. Of a material fact; 4. By the other party to the contract (or someone acting on the party‟s behalf); 5. On which the victim reasonably relies; and 6. Which causes damages. Non-Disclosure - Caveat emptor is still good law. “[I]n a bargaining transaction there is generally no duty to disclose information.” Absent a duty to disclose, it is not actionable for a party to fail to disclose material information prior to entering into a contract. Duties include: 1. Overruled by certain statutes and regulations 2. Non-disclosure v. active concealment a. “Positive action designed to hide the truth or to stymie the other party‟s investigation constitutes malfeasance that can result in liability for misrepresentation.” 3. Misleading half-truths 4. Duty to update 5. Duty disclose latent defects (some jurisdictions) Unconscionability - “If a contract is unreasonable and unconscionable, but not void for fraud, a court of law (judge) will give to the party who sues for its breach damages, not according to its letter, but only such as he is equitably entitled to. . . .” “Unconscionability has generally been recognized to include an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other party.” When a party of little bargaining power, and hence little real choice, signs a commercially unreasonable contract with little or no knowledge of its terms, it is hardly likely that his consent, or even an objective manifestation of his consent, was ever given to all the terms. In such a case the usual rule that the terms of the agreement are not to be questioned should be abandoned and the court should consider whether the terms of the contract are so unfair that enforcement should be withheld.” Procedural Unconscionability: Unfair Surprise: the clause was not obvious (no heading) and complex (party with higher bargaining power is obligated to explain); Inequality in Bargaining Power; and Extremely One-Sided Terms Covenants not to Compete (anti-competitive) – a two-step analysis: 1. Is the non-compete necessary to protect a clear business interest in a party‟s goodwill (customer relationships, etc.) or trade secrets? 2. Are the restrictions contained in the non-compete are reasonable in relation to that goodwill? a) Scope of subject matter: a. Van‟s should pass this part of the test. The goodwill involves primarily donut shop customers, and the noncompete is limited to restricting Wayman‟s ability to open a donut shop. b) Reasonable in Geographic Scope: a. Only if we scratch “or in any other county in which there is a Van‟s franchise”. Based on the Snelling case, it appears that Arizona permits blue penciling. b. We have only transferred the goodwill for the geographic area surrounding one single franchise. c. What would be our justification for the other franchises – other than anti-competitive reasons? MAYBE – protecting the trade secrets, but I am not certain a court will accept there are trade secrets to be protected. d. NOTE: It is arguable that even Maricopa County is too broad in geographic scope. We‟d need to do some additional analysis on that issue. c) Reasonable Duration: a. The rule = Duration should be based on the expected useful life of the goodwill or trade secret being protected. Blue Pencil Rule - 3 choices for overbroad covenants not to compete: 1. Strike down the whole clause as overbroad: 2. What I referred to in class as the “Strict Blue Pencil Approach:” If grammatically feasible, sever some words of the covenant leaving intact those parts of the covenant that were reasonable. If not grammatically feasible, the whole clause is unenforceable. 3. Some courts will simply limit the overbroad clause to its reasonable restrictions. D. Impracticability and Frustration of Purpose Pacta Sunt Servanda = promises must be kept though the heavens fall. The theory being that the breaching party should obtain self-protection by negotiating a protective provision in the contract. Section 261 – Impracticability Section 265 – Frustration 1. Occurrence of a contingency (something unexpected) that rendered performance commercially impracticable; 2. The contingency must have occurred through no fault of the party seeking nullification of performance and after the contract was entered into; k 3. k The contingency was a constructive condition precedent to the performance of k the k contract; and k 4. The risk of the contingency must not have k been allocated either by agreement or by k custom. k k Is a Writing Required? A. Statute of Frauds For six major classes of contracts, the general rule that oral contracts are enforceable does not apply because they are subject to the Statute of Frauds. The six categories are: 1. Suretyship contracts (a contract to answer for the debt or duty of another); 2. Executor-administrator contracts (a contract of an executor or administrator to answer for a duty of a decedent); 1. Occurrence of a contingency (something unexpected) that substantially frustrates a party‟s principal purpose for the contract; 2. The contingency must have occurred through no fault of the party seeking nullification of performance and after the contract was entered into; 3. The contingency was a constructive condition precedent to the performance of the contract; and 4. The risk of the contingency must not have been allocated either by agreement or by custom. I. 3. Marriage contracts 4. Contracts for the sale of real property or an interest in real property; 5. One-Year contracts (a contract that is incapable of being fully performed within one year from the making of the contract – NOTE: it must be impossible rather than just impractical); and 6. U.C.C. 2-201 (contracts for the sale of goods of $500 or more). I. Reading / Sanctity of the Contract A. Duty to Read Applies generally to all contracts. “A party who signs an instrument manifests assent to it and may not later complain about not reading or not understanding.” “[O]ne having the capacity to understand a written document who reads it, or, without reading it or having it read to him, signs it, is bound by his signature.” B. Interpretation (Plain Meaning Rule v. Broader Use of Extrinsic Evidence) 1. Specific terms are given greater weight than general terms. 2. Separately negotiated terms are given greater weight than standardized terms. 3. If there is an inconsistency between typed or handwritten terms and terms that are on a pre-printed form, the typed/handwritten terms will prevail over the terms of the pre-printed form. 4. In choosing among reasonable meanings, the instrument should be interpreted against the drafter (section 206 of Restatement 2 nd). 5. Courts prefer to construe terms so that they are lawful and operative rather than unlawful and inoperative. 6. All terms will be interpreted, where possible, as being reasonable. 7. Express terms have greater force than course of performance. 8. If one party knows of the other‟s meaning, but not vice versa, then courts will construe the language against the party than knew of the misunderstanding and could have corrected the error. C. Parole Evidence Rule – 3 Step Analysis 1. Is there an integration? Court must decide whether the written agreement is final (whether written agreement is an integration) – §209(2) [NOTE: this is a question of law – the “court” must decide]. Court decides this issue by looking at the writing itself – §209(3) [4 corners approach]. However, a writing that appears to be complete may be shown to be incomplete by “other evidence” – §209(3) [Softens the 4 corners approach]. 2. If there is an integration, is it complete or partial? If the agreement is found to be an integration, the next step in the analysis is to determine whether the integration is complete or partial – §210 Complete integration = “an integrated agreement adopted by the parties as a complete and exclusive statement of the terms of the agreement.” §210(1) Partial integration = “an integrated agreement other than a completely integrated agreement.” §210(2) I don‟t want to go into the complexities of the issue, but unless there is a “merger clause” most integrations will be partial. [MERGER CLAUSE = a clause in the agreement that states that the writing contains the entire agreement of the parties. See Bonus Materials below] Even with a merger clause, §216(2) provides a substantial out for courts to find a partial rather than a complete integration (e.g., all you need is a separate consideration on the parol agreement, and the integration in question should be deemed to be partial). As with the question of whether an agreement is an integration, whether the integration is complete or partial is to be decided by the judge and not the jury. §210(3) 3. If there is an integration, is the parol evidence admissible? The big question is whether the parol evidence that the party is trying to introduce is “inconsistent” with the integration or “within the scope” of the integration Assuming a partial integration, §213 provides: Prior inconsistent agreements are discharged (See also §216) Prior consistent agreements are admissible (See also §216) If a complete integration, §213 also provides: Prior inconsistent agreements are discharged (See also §216) Prior agreements that are “within scope” of integration are discharged, even if consistent (See also §216) I. Breach A. Condition versus Promise Promise = “A promise is a manifestation of intention to act or refrain from acting in a specified way, so as to justify a promisee in understanding that a commitment has been made.” Restatement (Second) § 2(1). Condition = “A condition is an event, not certain to occur, which must occur, unless its non-occurrence is excused, before performance under a contract becomes due.” Restatement (Second) § 224. Conditions Based on Intent of Parties: Express condition = The condition is “created by agreement of the parties” and is so expressed by the parties. Implied-in-fact condition = The condition is created by agreement of the parties, but is “not clearly expressed” by the parties. An implied-in-fact condition “is not spelled out in words but rather is „gathered from the terms of the contracts as a matter of interpretation.‟” NOTE: Implied-in-fact conditions are treated the same as express conditions – namely an implied-in-fact condition requires perfect performance or the promisor‟s duty to perform her promise is discharged. As a result, implied-in-fact conditions are sometimes referred to as express conditions. Constructive conditions = The condition is not created by agreement of the parties (either expressly or impliedly), but instead is supplied by the court in order “to do justice.” Restatement (Second) § 226, comment c. provides the following description: When the parties have omitted a term that is essential to a determination of their rights and duties, the court may supply a term which is reasonable in the circumstances (§ 204). Where that term makes an event a condition, it is often described as a “constructive” (or “implied in law”) condition. This serves to distinguish it from events which are made conditions by the agreement of the parties, either by their words or by other conduct, and which are described as “express” and as “implied in fact” . . . conditions. NOTE: Failure of a constructive condition is treated differently than failure of an express or implied-in-fact condition. Time Classification of Conditions: Condition precedent = “[A]n act or event . . . which, unless the condition is excused, must occur [(i.e., be satisfied)] before a duty to perform a promise in the agreement arises.” Oppenheimer case, p.8 (citing Calamari Hornbook). NOTE: Conditions precedent are the most common conditions that you will run into and will be where we focus our energy. Condition subsequent = “A condition subsequent is an event the existence of which, by agreement of the parties, discharges a duty of performance that has [previously] arisen.” NOTE: The Restatement (Second) does not use “condition subsequent” in its terminology due to easy confusion that can arise from its usage. Consider the following example (based on illustration 8 from Restatement (Second) § 224): A insures B‟s property against theft. The policy provides that B‟s failure to notify A within 30 days after loss shall “terminate” A‟s duty to pay. Conditions concurrent = Exist “where the parties are to exchange performances at the same time.” B. Substantial Performance v. Material Breach Substantial Performance As a general rule, courts reject mathematical formulas for determining whether substantial performance has occurred. Grun and Plante. “The test of what amounts to substantial performance seems to be whether the performance meets the essential purpose of the contract.” “Substantial performance as applied to construction of a house does not mean that every detail must be in strict compliance with the specifications and the plans. Something less than perfection is the test of specific performance unless all details are made the essence of the contract.” 1. The extent of the nonperformance. “The deficiency will not be tolerated if it is so pervasive as to frustrate the purpose of the contract in any real or substantial sense.” 2. “The answer is arrived at by weighing the purpose to be served, the desire to be gratified, the excuse for deviating from the letter of the contract and the cruelty of enforcing strict adherence or of compelling the promisee to receive something less than for which he bargained.” 3. Also important is the ratio of money value of the tendered performance and of the promised performance.” 4. Finally, “the purpose which the promised performance was intended to serve and the extent to which the nonperformance would defeat such purpose, or would defeat it if not corrected.” Material Breach (Jury) 1) To what extent, if any, the contract has been performed at the time of the breach. The earlier the breach the more likely it will be regarded as material. 2) A willful breach is more likely to be regarded as material than a breach caused by negligence or by fortuitous circumstances. 3) A quantitatively serious breach is more likely to be considered material. In addition, the consequences of the determination must be taken into account. C. Anticipatory Repudiation “The man who wrongfully renounces a contract into which he has deliberately entered cannot justly complain if he is immediately sued for a compensation in damages by the man whom he has injured: and it seems reasonable to allow an option to the injured party, either to sue immediately, or to wait till the time when the act was to be done, still holding it as prospectively binding for the exercise of this option, which may be advantageous to the innocent party, and cannot be prejudicial to the wrongdoer.” If A repudiates a promise in a contract, and the promise repudiated is minor such that A‟s breach is immaterial (i.e., A substantially performs the contract as a whole), then B is not relieved of its duty to perform its promises. B can, however, treat the immaterial breach as immediate and sue A immediately. I. Remedies 1. a. The Classic Remedies for Breach of Contract Damages – 2 Forms: (1) Expectancy Damages = Non-breaching party is to be put in “as good a position as he would have been in had the contract been performed.” The non-breaching party is entitled to the benefit of her bargain. ►Standard remedy for breach of contract ►BASIC FORMULA = Losses caused to non-breaching party + gains prevented – savings made possible. (2) Reliance Damages = Non-breaching party is to be “put in as good a position as he would have been in had the contract not been made.” ►Reliance damages are awarded when expectancy damages (lost profits) are too speculative or uncertain ►Reliance damages also awarded for certain types of contracts, such as doctorpatient contracts or contracts that are bound based on promissory estoppel ►RECOVERABLE: (a) Essential Reliance Damages (“those made in preparing to perform the contract, or in actually performing”) are recoverable in all jurisdictions (b) Incidental Reliance Damages (“those made by plaintiff because he anticipated that contract would be performed, but which do not relate directly to performance”) may be recoverable depending on jurisdiction ►OFFSETS: (a) Reliance damages generally may not exceed what expectancy damages would have been (b) EXAMPLE (from Emmanuels): P enters into contract with D to build a bridge for $150,000. P spends $100,000 on the construction when D repudiates contract. D is able to show that P would have needed to spend an additional $100,000 in order to complete contract (meaning P would have lost $50,000) Recovery = $100,000 in reliance minus $50,000 in expectation loss = $50,000 b. Restitution: Non-suing party must return to suing party “any benefit that suing party has conferred upon the [non-suing] party.” ►Plaintiff may request restitution as an appropriate measure for breach of contract - in particular where: (1) Expectancy damages (lost profits) are too speculative or uncertain; or (2) Completed contract would result in a loss ►Restitution also employed for quasi-contract ►Restitution damages may be greater than expectation damages (not limited to contract price): (1) Unlike reliance damages, restitution damages may exceed expectation damages (2) Restitution damages are calculated solely based on value conferred to defendant c. Specific Performance: ►Definition = “An order compelling a defaulting promisor to perform.” ►Black letter law states that courts “disfavor” specific performance and prefer granting monetary relief via damages or restitution. There are two ways of stating when an award of specific performance is available: (1) Specific performance will be awarded when legal remedies (damages or restitution) are “inadequate” (2) Also stated as: Specific performance will not be awarded unless plaintiff can show “irreparable” injury will result if equitable relief is refused ►We will see in CaseFile 47.0 that courts do not necessarily follow this rule very closely and specific performance is frequently awarded by courts. 2. Non-Compensatory Damages: a. Nominal Damages: For every breach of contract there is a remedy. In the event of a breach of contract that does not result in compensable damages, the court will award nominal damages. b. Punitive Damages: As a general rule, punitive damages are not available for a breach of contract. The big exception is that punitive damages may be awarded where the breach constitutes an independent tort. 3. Liquidated Damages: a. Where the parties stipulate the remedy for a breach of contract in the contract. b. Unenforceable if a Penalty: Liquidated damages clauses are generally enforceable unless they amount to a penalty, in which case they are unenforceable. Under the Common Law, to be properly characterized as liquidated damages and not a penalty, a liquidated damages clause must satisfy three basic requirements: (1) Parties must intend to provide for damages rather than a penalty; 1. Injury caused by breach must be uncertain or difficult to quantify; and 2. Sum stipulated must be a “reasonable” amount. While the test is often stated as a 3-prong test, courts have traditionally found the third prong of the test (“reasonableness”) to be the determinative factor for deciding whether a liquidated damages clause is enforceable. c. Proportionality of Damages to Liquidated Damages: The “reasonableness” prong requires the court to determine whether the liquidated damages are proportionate to the damages. In conducting this analysis, however, the court must determine whether it will compare the liquidated damages to the predicted damages at the time of the contract (ex ante approach) or to the actual damages that occur (ex post approach). Other Issues: Certainty: CASEFILE 52.0 Foreseeability: CASEFILE 53.0 Proportionality: CASEFILE 54.0 Mitigation: CASEFILE 55.0 Efficient Breach Theory: 4. a. b. c. d. 5. a. Basic Concept – Hornbook: ►“The theory of efficient breach holds that if a party breaches, and is still better off after paying damages to compensate the victim of the breach, the result is Pareto superior, that is, considered as a unit, the parties are better off because of the breach and the breach makes no party worse off. Consequently, the party who will benefit from the breach should breach.” ►In plain English, if after paying damages a party will make more money by breaching a contract than performing the contract, the party should breach the contract. In theory, wealth is created by breaching the contract. ►This theory eliminates negative consequences for “intentional” breaches: (1) In fact, it calls for parties to intentionally breach when economically justified (2) So long as the non-breaching party is made whole by damages, courts should not care whether the breach was intentional b. Criticisms of Theory: ►Calamari and Perillo point out a number of problems that exist with the efficient breach theory as a justification for willful breaches. ►They note that efficient breach theory “contains a number of simplifying assumptions that do not hold in the real world.” Specifically, efficient breach theory does not adequately take into consideration: (1) (2) Transaction costs (litigation and negotiation costs); Contract damages may not capture all losses of the non-breaching party (doctrines of foreseeability and certainty); and Cost of disruption of healthy business relationships (cost of “lawinspired distrust” amongst business persons). (3) ►While not discussed by Calamari and Perillo, it is easy to imagine that wide spread use of the efficient breach theory could add substantial costs to contracting as a whole (rather than create efficiencies). If performance by the other party is crucial, parties will be required to enter into hedging and other risk avoidance relationships to avoid the risk of breach rather than simply relying on the contract itself.
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