Efficient breach

Development of the theory

The theory of efficient breach seeks to explain the common law's preference for expectation damages for breach of contract, as distinguished from specific performance, reliance damages, or punitive damages. According to Black's Law Dictionary, efficient breach theory is "the view that a party should be allowed to breach a contract and pay damages, if doing so would be more economically efficient than performing under the contract." Expectation damages, according to the theory, give parties an incentive to breach when and only when performance is inefficient.

The first statement of the theory of efficient breach appears to have been made in 1970 in a law review article by Robert L. Birmingham in "Breach of Contract, Damage Measures, and Economic Efficiency".[1] The theory was named seven years later by Charles Goetz and Robert Scott.[2] Efficient breach theory is commonly associated with Richard Posner and the Law and Economics school of thought. Posner explains his views in his majority opinion in Lake River Corp. v. Carborundum Co., 769 F.2d 1284 (7th Cir. 1985).

Simple versions of the efficient breach theory employed arguments from welfare economics, operating on the premise that legal rules should be designed to give parties an incentive to act in ways that maximize aggregate welfare or achieve Pareto efficiency. More sophisticated versions of the theory maintain that parties themselves prefer remedies that incentivize efficient breach, as efficient breach maximizes the gains of trade from transacting. As Richard Posner and Andrew Rosenfeld put the point, "the more efficiently the exchange is structured, the larger is the potential profit of the contract for the parties to divide between them."[3]

Posner's illustration

Judge Richard Posner gave this well-known illustration of efficient breach in "Economic Analysis of Law":

Suppose I sign a contract to deliver 100,000 custom-ground widgets at $.10 apiece to A, for use in his boiler factory. After I have delivered 10,000, B comes to me, explains that he desperately needs 25,000 custom-ground widgets at once since otherwise he will be forced to close his pianola factory at great cost, and offers me $.15 apiece for 25,000 widgets. I sell him the widgets and as a result do not complete timely delivery to A, who sustains $1000 in damages from my breach. Having obtained an additional profit of $1250 on the sale to B, I am better off even after reimbursing A for his loss. Society is also better off. Since B was willing to pay me $.15 per widget, it must mean that each widget was worth at least $.15 to him. But it was worth only $.14 to A – $.10, what he paid, plus $.04 ($1000 divided by 25,000), his expected profit. Thus, the breach resulted in a transfer of the 25,000 widgets from a lower valued to a higher valued use.

Criticism

Some, such as Charles Fried in his "Contract as Promise", have argued that morally, A is obligated to honor a contract made with B because A has made a promise. Fried wrote, "The moralist of duty thus posits a general obligation to keep promises, of which the obligation of contract will only be a special case – that special case in which certain promises have attained legal as well as moral force." It would seem that Fried has since revised his interpretation.[4]

Others argue that the costs of litigation relevant to gaining expectation damages from breach would leave one or both of the original parties worse off than if the contract had simply been performed. Also, Posner's hypothetical assumes that the seller is aware of the value the buyer places on the commodity, or the cost of purchase plus the profits the buyer will make.[5]

Notes
  1. 24 Rutgers L.Rev. 273, 284 (1970) ("Repudiation of obligations should be encouraged where the promisor is able to profit from his default after placing his promisee in as good a position as he would have occupied had performance been rendered.").
  2. "Liquidated Damages, Penalties, and the Just Compensation Principle: A Theory of Efficient Breach", 77 Colum.L.Rev. 554 (1977).
  3. Richard A. Posner & Andrew M. Rosenfeld, Impossibility and Related Doctrines in Contract Law: An Economic Analysis, 6 J. Legal Stud. 83, 89 (1977).
  4. "Charles Fried, Contract as Promise, 2.0 — Yonathan Arbel". New Private Law. Retrieved 2015-10-16.
  5. Eisenberg, Melvin, Basic Contract Law, 8th ed. West Publishing, 2006, 209-214.
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References
  • H Wehberg, 'Pacta Sunt Servanda' (1959) 53(4) The American Journal of International Law 775
  • Gregory Klass, 'Efficient Breach', in Philosophical Foundations of Contract Law 362-387 (G. Klass, G. Letsas & P. Saprai eds., 2014)
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