Why do we enforce contract promises?

Over the course of my professional career, Law and Economics has grown from one school of thought among many to one so dominant that many of its postulates have virtually become unquestioned premises from which legal reasoning begins. 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 of their capacity to maximize the society-wide allocation of resources. Thus, it is said that the contractual promise has no moral value over and above its economic value. This view both explains why typically someone suing for breach of contract can recover only the financial equivalent of the benefit they would have received had the contract been performed. There is no additional quantum of damages added to provide an incentive not to breach.

Thus, it is said, a contractual promise is in fact a promise either to fulfill the promise or to pay the damages that result from breach. This view, it is argued, has long been the view of the common law, as exemplified by Oliver Wendell Holmes’ late 19th Century statement 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.” Thus, 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 a different deal, that result is not merely tolerable — it is to be desired. Such a breach of promise is known as an “efficient breach” because it theoretically results in an increase in overall resources: the party injured by the breach is supposed to get everything he was supposed to get under the contract, the breaching party is getting something better, and the new party with whom the breaching party contracts is getting a deal he would not otherwise have gotten.

The Law and Economics view is by no means the only one current in the theorizing about the basis for enforcing contractual promises (and the interpretation Law and Economics devotees put on Holmes’ statement is disputed). 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 to virtual unquestioned dogma that unregulated free markets always result in the highest social good. One problem, though, is that unregulated free markets entrench the power of the wealthiest. So people bound by promises (the “promisor”) can force the person to whom they are bound (the “promisee”) to change the terms of the promises if the promisor has greater financial ability to force the promisee into a legal resolution that is unacceptable to 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 law, the threat of being limited to that remedy can be a powerful one. Thus, as the New York Times pointed out last week,

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 the bonuses paid to AIG employees that the contractual promises are too sacred under the law 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 financial strength and political influence? I don’t think I know.

Bail out the Big Three!

Thanks to the Cleveland Plain Dealer for this and for this, from Thomas Suddes:

It’s hard to imagine anything more disgusting than the blowhards who claim that consigning Chrysler, Ford and General Motors to Bankruptcy Court would be a good thing.

In fact, cutting Big Three workers’ wages would also cut spending at supermarkets and malls, shrinking many other Ohio paychecks, too.

And benefit cuts would add clients to Ohio’s Medicaid tab, which bulges now like a glutton’s waistline.

Critics of a Big Three bailout relish double-talk – “magic of the market,” “creative destruction” – because it hides the cruel, real-world truth. A collapse of the Big Three would destroy Ohio families and towns, especially in Greater Cleveland and the Dayton area. Ohioans in Twinsburg, Lordstown, Warren, Moraine and a score of other towns deserve better from their country than to be declared human surplus.

According to data from the state Department of Development, almost 15,000 Ohioans work for General Motors, about 11,000 for Ford, almost 7,000 for Chrysler and 6,000 for Delphi, the parts manufacturer. If you want to argue that losing or “downsizing” those payrolls would be no big deal, try to sell that story elsewhere. I’m from Youngstown and my father worked in a steel mill. So did the whole neighborhood. Correction: What was the neighborhood. End of story – a heartbreaking story.

In the 1970s, Wall Street and Washington caused American steel’s troubles, but the “Free to Choose” economic cult predictably blamed the United Steelworkers. Union members had the gall to prefer a living wage and decent benefits to company-town serfdom. Yet the steel those “overpaid” men and women produced – not wage cuts dreamed up by economists with lifetime jobs – is what built Ohio.

Sure, there’s more in play politically in the Detroit bailout stalemate than campaign contributors’ 30-year war on the living standards of American working families.

As Gerald F. Seib wrote so eloquently in Tuesday’s Wall Street Journal, congressional factors also are at work. First, “Western, environmentally minded [Democratic] leaders . . . don’t see the auto companies as particularly important to their region, or friendly to their green causes.” Second, among congressional Republicans, “foreign-owned auto plants concentrated in the Republican-leaning . . . South . . . stand to benefit if the Big Three American companies go down.”

Suddes is right that a bankruptcy consigns Ohio (and Michigan, and several other states — but I live and work in Ohio and Michigan) to economic disaster.  In bankruptcy, the debtor delays and reduces its payment of its debts, and it cancels contracts without any liability.  In other words, if any of the Big Three go into bankruptcy, every business that services the auto industry directly or indirectly will be jeopardized.  Perhaps these businesses will be reconsituted somewhere and some way in the future, but in the meantime entire cities, towns, and states will be uprooted.  Richard Shelby of Alabama declares in the Senate that we can’t bail ou the Big Three.  He doesn’t mention the benefit that would bring to the non-union, Japanese and German auto makers with factories in his state. Some people do mention the United Auto Workers, as if its mere existence is proof of corruption and ineptness, but they don’t mention the enormous concessions the UAW has made in the past several years.  It is time to help out Detroit and the entire surrounding Great Lakes region.