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Breach of Contract in Complex
Commercial Litigation:
Damage Theories and Outcomes
in the Winstar Matters
Presentation by Steven J. Davis
Vice President, CRA International
University Club of Chicago
June 5, 2007
Outline
I. Thrift Industry Insolvencies and Response
II. The Winstar-Related Cases
III. On Damages in Breach of Contract
IV. Assessing Damage Outcomes in the
Winstar Matters
V. Some Lessons
I. Thrift Industry Insolvencies
and Response
The S&L Industry in the 1980s
• Historically, Savings and Loan Institutions (S&Ls) pooled
small savings and time deposits and used the proceeds to
fund long term, fixed-rate mortgages.
• Most S&Ls became insolvent during the 1980s.
• Initial wave of insolvencies caused by historically high
interest rates in the late 1970s and early 1980s. As interest
rates rose,
– The value of S&L loan portfolios fell dramatically
– Spreads between return on assets and cost of funds turned negative.
• Later insolvencies caused by a combination of
– Unwise regulatory reforms
– Lax oversight by government officials
– Fraud, mismanagement and excessive risk taking
• The scale of the insolvencies vastly exceeded the reserves of
the Government‟s deposit insurance fund (FSLIC).
Supervisory Mergers
• The government encouraged “supervisory mergers” to prevent
the collapse of failing S&Ls and reduce demands on FSLIC.
• To facilitate takeovers of failing S&Ls by stronger institutions,
the Government relied on cash infusions and several other
inducements:
– Opportunity for acquirer to circumvent restrictions on
branch banking and interstate banking
– Relaxation of certain rules re loan portfolios
– Assurance of continued forbearance w.r.t. capital
requirements of acquirer
– Use of “supervisory goodwill” to meet regulatory
capital requirements
– Other capital credits and allowances
– Special tax breaks
Supervisory Goodwill
• Under the “purchase method of accounting”, the
excess of liabilities over assets in the acquired
institution is designated as “supervisory goodwill”
and treated as a form of intangible capital.
• The goodwill created in this manner had an
amortization horizon as long as 40 years.
• Supervisory goodwill counted towards the
regulatory capital requirements of the merged
institution.
• Effectively, the government allowed the negative net
worth of the acquired institution to substitute for
actual capital for the purpose of meeting regulatory
capital requirements.
Example: Creating Supervisory Goodwill
• Failing S&L has $250 million in assets and $300
million in liabilities net worth of -$50 million.
• When acquired, this excess of liabilities over assets in
the failing S&L becomes “supervisory goodwill” in the
merged institution.
– See charts below for details and a comparison of alternative
methods to account for the acquisition.
• With a 5% capital requirement, each dollar of capital
can support $20 of loans.
• So, in this example, supervisory goodwill can support
an extra $1 billion in loans (20 X $50 million).
• Note: The government deposit insurance system
greatly increased the feasibility and attractiveness of
this strategy for poorly capitalized S&Ls.
Balance Sheet of a "Strong" S&L (Acquirer)
Assets Liabilities and Equity
Mortgage Loans $ 450 Deposits $ 400
Other Tangible Assets $ 150 Other Liabilities $ 170
Owners' Equity $ 30
Total Assets $ 600 Total Liabilities and Equity $ 600
CAPITAL RATIO = (30/600) = 5%
Balance Sheet of a "Weak" S&L
Assets Liabilities and Equity
Mortgage Loans $ 200 Deposits $ 200
Other Tangible Assets $ 50 Other Liabilities $ 100
Owners' Equity $ (50)
Total Assets $ 250 Total Liabilities and Equity $ 250
CAPITAL RATIO = (-50/250) = -20%
Balance Sheet After Merger of "Strong" and "Weak" S&Ls
Using the Pooling of Interests Method of Accounting
Assets Liabilities and Equity
Tangible Assets of "Strong" $ 600 Deposits and Other Liabilities of "Strong" $ 570
Tangible Assets of "Weak" $ 250 Deposits and Other Liabilities of "Weak" $ 300
Owners' Equity in the merged S&L $ (20)
Total Assets $ 850 Total Liabilities and Equity $ 850
CAPITAL RATIO = -2.3%
Balance Sheet After Merger of "Strong" and "Weak" S&Ls
Using the Purchase Method of Accounting
Assets Liabilities and Equity
Tangible Assets of "Strong" $ 600 Deposits and Other Liabilities of "Strong" $ 570
Tangible Assets of "Weak" $ 250 Deposits and Other Liabilities of "Weak" $ 300
Subtotal $ 850 Subtotal $ 870
Supervisory Goodwill $ 50 Owners' equity in the merged S&L $ 30
Total Assets $ 900 Total Liabilities and Equity $ 900
Capital Ratio = Capital / Assets
CAPITAL RATIO = 3.5%
Leverage Ratio = Assets / Capital Debt / Equity Ratio = Debt / Equity
FIRREA (1989)
• The Financial Institutions Reform, Recovery and
Enforcement Act (FIRREA) and its implementing
regulations introduced three types of capital
requirements:
– Tangible capital (could not be met by goodwill)
– Core capital, which permitted limited amounts of
“qualifying supervisory goodwill”
– Risk-based capital, a percentage of risk-weighted assets
• FIRREA also mandated a rapid phase-out of
supervisory goodwill and required thrifts to exit the
real estate development business.
• Guarini amendment in 1993 disallowed certain tax
deductions promised in some supervisory mergers.
FIRREA (1989)
• For our purposes, the chief features of FIRREA
are the greatly accelerated amortization of
supervisory goodwill and the strict requirements
for uniform application of regulatory capital
standards (i.e., no further discretionary
forbearance by the regulatory authorities).
• Roughly $10 billion in “qualifying goodwill”
became subject to rapid phase out due to
FIRREA and implementing regulations.
• Almost immediately, 500 S&Ls fell out of
compliance with regulatory capital standards.
II. The Winstar-Related Cases
The “Winstar” Matters
• 130+ cases with related fact patterns filed in the
U.S. Court of Federal Claims during the 1990s.
• Common elements:
– In the course of supervisory mergers in 1980s, the
Government allegedly entered into regulatory contracts re
the treatment of supervisory goodwill, other capital credits
and forbearance with respect to capital requirements.
– The contracts were allegedly breached by FIRREA and its
implementing regulations (or by the 1993 Guarini
amendment to FIRREA.)
• Huge potential liability for Government: Estimated
damages of $20-30 billion or more as of 1998-99
plus $200 million in litigation costs.
Number of Winstar-Related Cases Initiated by Quarter, 1990-1999
50
45 Q3 1995
44 cases October 1995: Supreme
40
Number of cases
Court grants writ of certioari
35 to hear the Winstar case.
30
25 Q4 1995
24 cases
20
15
10
5
0
90
90
91
91
92
92
93
93
94
94
95
95
96
96
97
97
98
98
99
99
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
1
3
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
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Q
Q
Sources: List of Winstar cases from USCFC; http://www.uscfc.uscourts.gov/winstar.htm; United
States Reports, Volume 518, Cases Adjudged in the Supreme Court at October Term, 1995.
US v. Winstar et al. (1996)
• The Supreme Court ruled that:
– The United States entered into contracts during
the 1980s that allowed special accounting
methods in the acquisition of certain failing S&Ls.
– The new capital requirements mandated by
FIRREA (1989), as applied to the acquiring
institutions, breached the terms of the contracts.
– The Government is liable for damages in breach
of contract.
• The Supreme Court remanded to the Court of
Federal Claims for determination of damages.
Early Outcomes on Damages
• August 1998: initial judgment of $2.8 million
against the government in Winstar.
• April 1999: initial judgment of $909 million
against the government in Glendale Federal
Bank vs. The United States, the second
Winstar-related case tried on damages.
– As of June 1989, shortly before the enactment of
FIRREA, Glendale had about $550 million of
unamortized supervisory goodwill.
– Thus, Glendale seemed to confirm concerns about
huge government exposure in Winstar-related
cases.
Glendale Federal Bank v. US
• Bench trial lasted 14 months
– 150+ days of testimony, 20,000 pages of trial transcripts
– $100 million in litigation costs, per rough estimate of trial court judge
• Judgment of $909 million for plaintiffs:
– $528 million for restitution of “benefits conferred on government”
– $381 million for non-overlapping (post-breach) reliance damages
• The court calculated restitution as the excess of liabilities over
assets in the failing institution at acquisition, less the value of
(certain) benefits that Glendale received from the contract.
• Reliance damages were awarded mainly for “wounded bank
damages” – the argument being that Glendale lost an historic
advantage in its cost of funds because the breach forced
Glendale out of capital compliance.
• The restitution award did not survive appeal, because the value
of the benefits conferred on the government are “both
speculative and indeterminate.”
The Complexity of
Damages Determination
“The court recognizes that damages,
particularly involving a thrift that entered a
40-year contract 18 years ago, which was
breached nearly ten years ago,
necessarily is not going to be found with
the precision that one could determine
damages resulting from the breach of a
smaller, more discrete contract.” [Trial
court opinion in Glendale Federal v. United
States, 43 Fed. Cl., at 399 (1999)]
Courts‟ Attitude Toward Expectation
Damages in Winstar Matters
• “The complexity, breadth and length of the contract which
was breached make it difficult to award expectancy
damages, … which the court believes would be most
consistent with the very purpose of contract law. The
difficulty, as plaintiff‟s model demonstrates, is the bank is
operating in a dynamic market, making dynamic decisions,
and responding to millions of stimuli in order to run a
profitable enterprise.” [Trial court opinion in California
Federal Bank, 43 Fed. Cl., at 404 (1999)]
• “Expectation damages are difficult or impossible to prove
due to the length of time which has elapsed since the breach
of contract occurred and the fact that many of these thrifts
were closed at the hands of federal regulators as a result of
breach.” [Watson (1999), summarizing court‟s view in
several Winstar matters]
III. On Damages in Breach
of Contract
Goal of Contract Law
• From the perspective of economic efficiency, the
goal of contract law is to maximize social welfare.
– Focus is usually on parties to the contract.
– In which case, efficiency boils down to maximizing the
(expected) joint value of the contractual relationship to
the parties.
• Legal rules regarding
- Contract formation - Interpretation
- Enforcement - Holdup
- Breach - Mitigation
- Remedies and damages
all affect the efficiency of contractual relationships.
Damage Measures
• Damage measure: A rule or formula that
governs what a party in breach should pay to the
non-breaching party.
• Damage measures affect the efficiency of
contractual relationships in several ways:
– Incentives to perform
– Incentives to take actions in reliance on the contract
– Incentives to mitigate losses in the event of breach
– Cost of writing contracts
– Incentives to renegotiate
– Opportunities to allocate risks
– Incentives to seek and form contractual relationships
Expectation Damages
• Expectation damages compensate the
injured party for the harm caused by the
breach. They equal the value of
performance to the non-breaching party.
• Usually the preferred remedy from an
economic perspective, because expectation
damages provide the proper incentive for
efficient performance (and efficient breach).
• In practice, expectation damages can be
hard or easy to calculate, depending on
circumstances.
Example: Efficient Performance
• A buyer wants to acquire a
machine that he values at 50. Cost Probability
• A seller‟s cost of producing the
machine is uncertain at the
10 (low) 30%
contract date – see table. 30 (mid) 50%
• A mutually optimal complete
contract calls for delivery only 100 (high) 20%
when the cost turns out to be less
than 50, which occurs with
probability 0.8 in this example. The (expected) joint value of a
• That is, an optimal contract contract that calls for
allows for non-performance when performance in all states is
the cost of performance exceeds (.3)(50-10) + (.5)(50-30) +
the value of performance. (.2)(50-100) = 12 +10 – 10 = 12
The joint value of the optimal
contract is 12 + 10 = 22.
Example Continued:
Hypothetical Incomplete Contract
• Hypothetical contract: The manufacturer agrees
to produce and deliver the machine in return for
a payment of 40. The contract contains no
provisions for non-performance or damages in
the event of breach.
• How should the law deal with breach?
– Requiring specific performance in all circumstances
yields a joint value of 12.
– High damages, 50 or more, lead to performance in
all states and, hence, a joint value of 12.
– Lower damages, less than 50, lead to (efficient)
breach under high costs, yielding a joint value of 22.
Example Continued: Expectation
Damages and Efficient Performance
• Expectation damages yield efficient performance:
– The value of performance to the non-breaching party is
50 – 40 = 10. This is the harm to the buyer if the seller
breaches.
– Setting damages to 10 yields performance under low and
mid costs but not under high costs, replicating the efficient
outcome.
• Expectation damages continue to provide the proper
incentive to perform in richer examples (continuum of
possible costs) and in broader circumstances
(uncertainty about seller costs and buyer values).
– Damages above the expectation level yield too little breach.
– Damages below the expectation level yield too much breach.
Expectation Damages and Mitigation
• An efficient damage measure provides
incentives to mitigate harm caused by breach
when the resulting savings exceed the cost of
mitigation. A proper measure of expectation
damages takes this point into account:
– Expectation damages (reformulated):
(Expected) losses that would be sustained by the
non-breaching party had he optimally mitigated –
whether or not he actually did so – plus the costs
of optimal mitigation.
– This damage measure deters inefficient breach
and encourages cost-saving mitigation.
• “The general rule of a non-breaching party‟s
responsibility for mitigation is that „damages are
not recoverable for loss that the injured party
could have avoided without undue risk, burden
or humiliation.” [Restatement (Second) of
Contracts, Section 350 (1) (1979), as quote in
Commercial Fed v. U.S., 22 January 2004]
“Further, „[a]s a general rule, a party cannot
recover damages for loss that he could have
avoided by reasonable efforts.‟”
Expectation Damages and Reliance
• Under certain conditions, expectation damages
mimic the outcomes of a completely specified
contract that is mutually preferred by the parties (at
contract formation). In this limited but important
respect, expectation damages are optimal from an
efficiency perspective.
• Expectation damages provide strong, but
imperfect, incentives to take actions in reliance on
the contract.
– E.g., expectation damages can induce excessive
expenditures in reliance on performance, because the
non-breaching party receives the value of full
performance even when breach is efficient.
• Neither expectation damages nor any other
simple, practical damage measure achieves
optimality in all circumstances.
Restitution
• “When proof of expectancy damages fails, the
law provides a fall-back position for the injured
party – he can sue for restitution. The idea
behind restitution is to restore – that is, to
restore the non-breaching party to the position
he would have been in had there never been
any contract to breach. …In other words, the
objective is to restore the parties to the status
quo ante.” [Quoting from the 9th Circuit opinion
in Glendale, 16 December 2001, emphasis
added.]
Reliance Damages
• The purpose of reliance damages is to place the injured
party “in as good a position as he would have been in
had the contract not been made.” [Restatement (Second)
of Contracts]
• Unlike restitution, reliance damages include
“expenditures made in preparation for performance or in
performance, less any loss that the party in breach can
prove with reasonable certainty the injured party would
have suffered had the contract been performed.”
• The comments to the Restatement point out that
restitution may be equal to the reliance interest, but
ordinarily restitution is smaller because it does not
include “expenditures in reliance that result in no benefit
to the other party.”
Reliance vs. Expectation Damages
• It is often said that reliance damages are less than
expectation damages, “because it would be
irrational for a contracting party to plan to spend
more on reliance than performance is worth;
otherwise, the contract would have negative worth to
the party spending on reliance.”
• This logic is correct but easily misapplied when – as
in the Winstar matters – the breach occurs years
after contract formation.
– When breach occurs long after contract formation, the
value of remaining performance can be much smaller than
the value of performance already delivered.
– Hence, reliance damages can greatly exceed expectation
damages (i.e., the value of remaining performance).
IV. Assessing Damage
Outcomes in the Winstar Matters
How Did the Breach
Affect Plaintiffs?
• FIRREA greatly shortened the time period over
which supervisory goodwill could be counted
towards regulatory capital requirements. It also
eliminated certain other capital credits created in
supervisory mergers.
• As a result, many S&Ls fell out of compliance with
regulatory capital standards.
• Non-complying S&Ls had three main options:
– Shrink liabilities and assets to achieve compliance
– Re-capitalize to achieve compliance (or cut dividends)
– Exit
Analyses of Lost Profits, Use
Value, etc., in the Winstar Matters
An expectancy approach, yes, but in practice, one with
several problems:
• Highly speculative, not subject to any ready source of
discipline
• Difficult issues of causation
• Keenly susceptible to hindsight bias and undue
optimism by plaintiffs re returns on their but-for
investment strategies
• Lost profits analyses also tended to ignore or
downplay opportunities for plaintiffs to mitigate the
cost of breach.
Estimating Expectation Damages
Caused by Lost Supervisory Goodwill
• Key economic insight: The cost of re-capitalizing is
an upper bound for the harm to shareholders caused
by the breach.
• Why?
– S&L need not forego good investment opportunities because
of reduced scope for leverage caused by the breach.
– Instead, it can raise whatever additional capital it needs to
preserve such valuable opportunities.
– Could S&Ls, in fact, access capital markets? Yes.
– S&Ls that did not raise new capital (or reduce dividends) to
restore compliance presumably concluded that the costs of
raising capital exceeded the net value of the foregone
opportunities.
Could Thrifts Raise Capital
in the Wake of FIRREA?
• “Between the end of 1989 and the end of 1993, there
were nearly 500 equity and debt offerings by thrifts
and thrift holding companies with total amounts of
between $250 million and $1.3 billion per quarter.”
[Expert Report of Jonathan Arnold and Steven Davis
in Southern National Corp. vs. United States]
– In total, the industry raised more than $15 billion in capital
during the period. (In comparison, recall that FIRREA
affected about $10 billion in qualifying goodwill.)
– Thrifts in every region of the country raised capital during
this period.
– Some capital-raising thrifts had supervisory goodwill on the
books at the time of FIRREA‟s enactment, some did not.
Costs of Re-Capitalizing
• Flotation costs (direct cost of issuing new equity):
– Registration fees
– Management and underwriting fees
– Cost of legal and accounting services
– Other direct expenses
• Adverse information effects on equity price
– A potentially relevant factor when “insiders” with private
information determine timing and amount of equity issue.
– Not very relevant when the fact and timing of equity issue
are compelled by external forces.
– Of doubtful relevance anyway in a heavily regulated
industry subject to routine examinations and compulsory
disclosure of detailed financial information.
• Wealth transfers from S&L stockholders to debt
holders and other creditors – including the
government deposit insurance fund.
Cost of Recapitalizing: Advantages
as a Measure of Damages
• Promotes efficient contractual relationships
– Proper incentive to perform
– Proper incentive to mitigate
– Strong incentive to rely
• Obviates need for speculative lost profits analysis
• Easy to quantify, especially relative to lost profits or
restitution of conferred benefits
• Cuts through complexity and inaccuracy of the
accounting numbers
• Does not deter efficient regulatory reform
Glendale Court‟s Reaction
• “The court finds the testimony of Nobel Laureate
Merton Miller, a brilliant scholar, regarding the value of
leverage of little utility in this case. Professor Miller
testified that any contention that Glendale lost
something of value was meritless because leverage,
standing alone, has no value. Plaintiffs convincingly
point out that, notwithstanding the general principle of
finance for which Dr. Miller won the Nobel prize in
Economics in 1990, the situation of thrifts and other
lending institutions is different, because they have
access to low-cost government insured borrowings
(retail deposits) which are unavailable to other
institutions.”
Summary of Outcomes in Winstar-Related Cases
# of Cases
All Winstar cases (net of consolidation) 131
Voluntary dismissal 42
Victory for government on liability grounds 16
Statute of limitations 6
Cases adjudicated to a judgment on damages 36
Cases settled for positive damages 9
Ongoing cases 28
Cases appealed on damages:
Final damages = Initial damages 14
Both decisions for defendant (damages = 0) 9
Both decisions for plaintiff (damages < 0) 5
Final damages > Initial damages 4
Final damages < Initial damages 11
Number of cases with positive damages 26
Total damages awarded to date: $1.24 Billion
Notes: Three cases with positive damages involved Guarini-related litigation.
V. Some Lessons
Lessons
1. A proper economic analysis can deliver a sound,
practical approach to expectation damages in
complicated cases. In the Winstar cases, the cost of
recapitalizing provides an upper bound to damages
caused by the loss of supervisory goodwill
• The cost of recapitalizing is quantifiable using hard data.
• This damage measure has desirable efficiency properties.
• It obviates the need for a speculative analysis of lost profits.
• It cuts through the inaccuracy and complexity of the
accounting numbers.
Lessons
2. Firmly establish factual predicates for
damage measures and the underlying
economic theory, even when they are
well known or “obvious” to informed
experts.
3. Use simple formulations of economic
insights that are easy for the non-expert
to grasp. More general formulations are
more powerful but can also be harder to
understand.
Lessons
4. Some courts give undue weight to problematic
accounting measures.
5. The law should promote efficient contractual
relationships. Applying this principle can help
to identify undesirable features of certain
damages measures.
6. In matters that involve breach of contract by
the government, damage measures should be
designed to maximize the joint value of the
contractual relationship (as in ordinary contract
law) and to promote efficient legislative
responses to regulatory problems.
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