August 21, 2015
What Is an ‘Efficient Breach’ of Contract?
Breaching a contract is usually a bad thing. Generally speaking, the party who materially breaches a contract (the “breaching party”) is responsible to pay pecuniary damages (i.e., money damages) to the other party. In a breach of contract case, a court’s goal, is to put the both of the parties in the (financial) position in which they would have been, had neither party breached the contract. Under the general legal theories according to which contract law operates, two broad categories of money damages are available under appropriate circumstances: expectation damages and incidental damages.
For most of the rest of this article, I will be discussing expectation damages. Expectation damages “are intended, in the words of the Restatement, to give the injured party ‘the benefit of his bargain by awarding him a sum of money that will, to the extent possible, put him as good a position as he would have been in had the contract been performed.’ Restatement, Second, Contracts § 347, comment a.” (Hamilton, 1992, p. 14) Why is this a good way to measure damages, though? “This measure of recovery has been defended on the ground that it is ‘efficient’ in the sense that it makes it likely that the goods or services that are the subject of the contract will wind up in the hands of a person who values them most highly.” Id.
Essentially, what this means is that the parties will have an incentive not to breach a contract only if the potential gain to the party who makes a promise (the “promisor”), a the contract, is not more than the loss the person to whom the promise is made (the “promisee”) would suffer if the promise is broken. What if the potential gain to the promisor is higher than the loss the promisee would suffer? Then, one might argue, the promisor ought to be permitted to breach the contract, pay the promisee, and earn a higher profit. In the Economic Analysis of Law discipline, this is referred to as an “efficient breach” of contract.
To better understand this concept, let’s examine an illustration. Let’s say, on August 22nd, Megan agrees to purchase a run-down house from Herbert for $20,000. On August 22nd, the parties sign a contract for the purchase and sale of real estate, and Megan pays Herbert $1,000 as a down payment, owing the other $19,000 on the closing date. Their contract says they are supposed to close on the property on October 6th. Between the 22nd of August and the 6th of October, what if Herbert gets an offer to purchase the same house for $50,000 from Chris?
Herbert has an economic incentive to breach the contract by selling the house to Chris for $50,000 if the only consequence to Herbert is that he would have to pay Megan $20,000–Megan’s expectation damages for losing the benefit of the bargain of her contract with Herbert. “In the view of some scholars, this is as it ‘should be.’ R. Posner, Economic Analysis of Law § 4.8 at p. 107 (3d ed. 1986).” Id.
Are Efficient Breaches Really Efficient?
Some scholars have criticized “efficient breach” of contract as being, well, not really all that efficient. Part of this criticism has to do with the fact that, after a breach, often lawyers get involved and drive up the costs of resolving the dispute over the breach. Also, the most efficient thing to do, instead of “efficiently breaching” a contract is for the would-be-breaching party to bargain with the other party or parties to the contract for the right to reallocate goods and services to a third party. The outcome of such bargaining would be a contract modification instead of a breach of contract.
This requires a little preventive legal thinking! Hamilton & Raw, in Cases and Materials on Contracts, say, “Talk before breach is very likely to be less expensive than talk after breach, because afterwards lawyers usually do the talking.” Id. I say, however, that lawyers can do the talking both before or after a breach, and even when lawyers do the talking before a breach, their talking doesn’t necessarily have to result in higher costs to the business. After all, your General Counsel should be doing this very kind of thing for your business!
Taking a preventive legal approach to managing your obligations under the terms of your contract is far easier to do when you have General Counsel legal services. Executive Legal Professionals, and a few other firms, offer subscription-based General Counsel legal service plans, which often include services like contract (re)negotiation and modification. Under plans like Signet™ General Counsel from Executive Legal Professionals, businesses and entrepreneurs can have General Counsel legal services for a regular subscription fee.
Moral Objections To Efficient Breach Of Contract
Some people have asked: once a buyer acquires a right to goods they have promised to purchase, don’t those goods belong to the buyer?
“If so, the seller’s sale to someone who valued them more highly than the buyer is no more justified than if a burglar entered your house and took a painting that he valued more highly than you did. On this view, the seller’s ‘profit’ from breaking the contract should belong to the buyer. See Colorado Rev.Stat.Ann. § 5-12-102(1) ” … creditors shall receive interest as follows:
‘(a) When money or property has been wrongfully withheld, interest shall be in an amount which fully recognizes the gain or benefit realized by the person withholding such money or property from the date of wrongful withholding to the date of payment or to the date judgment is entered, whichever first occurs…’
Great Western Sugar Co. v. KN Energy, Inc., 778 P.2d 272 (Colo.App. 1989) (applying § 5-12-102(1) to breach of a contract to sell natural gas).” Id.
This view of efficient breach, however, is subject to the following criticism. The seller’s sale to someone who valued them more highly than the buyer is, in fact, more justified than if a burglar entered your house and took a painting that he valued more highly than you did, because the seller would be paying you expectation damages, whereas the burglar would not. Moreover, the seller is enhancing the value of the goods by directing resources to their highest and best use (possession by someone who values them most). Finally, the seller is creating (or, at least, preserving) wealth for the prospective buyer who receives expectation damages, for himself, and for the ultimate buyer who receives the goods; creating wealth for all these people justifies the receipt of profits the seller receives. The burglar does nothing to preserve the wealth of the victim of his art theft, whereas the seller who pays expectation damages does; that is the important distinction which destroys the “moral objection” to efficient breach of contract.
One still might argue one a promise is made it should never, ever be broken for any reason, under any circumstances. That seems like a silly, arbitrary rule to which I would not want to be held, and, I suspect, neither would anyone else.
Heading Into the Breach
Once more unto the breach, dear friends, once more;
Or close the wall up with our English dead.
In peace there’s nothing so becomes a man
As modest stillness and humility;
But when the blast of war blows in our ears,
Then imitate the action of the tiger. . . .
Henry The Fifth Act 3, scene 1, 1–6
If you’re headed into a breach of contract, because someone has made you a better offer, it might be okay. Just remember, you would do well to communicate with the other party with whom or with which you have contracted, and try–in a preventive way–to avoid litigation by having your General Counsel negotiate a modification of your contract. By avoiding a breach of contract, through contract modification, you may save yourself the cost of a law suit, not to mention the losses of time, focus, and effort which attend such costly endeavors.
In summary: (1) have General Counsel legal services, (2) use written contracts, (3) modify written contracts before an imminent breach, if breaching a contract appears efficient, and (4) don’t feel bad about not following through on a contract. Some deals were made to be changed. That’s business. Having savvy professionals in your support team can help you change horses midstream without falling in the water. If you’re looking for that kind of help, please visit Executive Legal Professionals, PLLC online at ExecutiveLP.com or give us a call at (615) 669-6566.
- Hamilton, R., & Rau, A. (1992). Enforcement of Promises. In Cases And Materials On Contracts (2nd ed., pp. 14-16). St. Paul, MN: West Pub.
This article may be freely reprinted or distributed in its entirety in any e-zine, newsletter, blog or website. The author’s name, bio and website links must remain intact and be included with every reproduction. View general information about this license; or view detailed legal information about this license.