Contract Law: Unconscionability, Performance and Remedies

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Can courts declined to enforce unconscionable contracts? And how to decide whether contracts are unconscionable?

If the court finds as a matter of law… any clause of the contract to have been unconscionable at the time it was made, the court may refuse to enforce the contract…

Uniform Commercial Code, 2-203

According to the UCC, the primary factors in determining unconscionability are whether it causes oppression and unfair surprise to one of the parties to a contract. Judge Wright went into a considerably deeper discussion of unconscionability’s meaning in his own opinion:

  1. an absence of meaningful choice on the part of one of the parties
  2. contractual terms which are unreasonably favorable to the other party. 

Judge Wright nevertheless, noted that meaningful choice could be negated by gross inequality of bargaining power and by a party’s lack of opportunity to understand the terms of the contract. Another common way of talking about unconscionability, is to distinguish between procedural unconscionability on one hand, and substantive unconscionability on the other. Usually, some mixture of both must be present for a court to declare a contract unconscionable.

Refers to
Procedural unconscionabilityThe defects in the bargaining process.
Factors include fine print, unequal bargaining power and lack of education.
Substantive unconscionabilityThe unfairness in the outcome of the process, the terms of the agreed upon contract.

The distinction between procedural and substantive unconscionability maps nicely onto Judge Wright’s requirements of the “absence of meaningful choice” and “unreasonably favorable terms” respectively. They also map onto the factors in UCC 2-302 comment one, the issues of oppression and unfair surprise. Where there is procedural unconscionability, the victim is surprised to learn about the contract substantive unfairness.

Libertarians would tend to be more concerned about procedural unconscionability. Substantively unconscionable terms could be problematic because they are evidence of procedural unconscionability. If the term is so unfavorable, that no person in their right mind would have agreed to it, then the existence of substantively unconscionable terms in a contract is evidence that there must have been some procedural defect in contracting.

Enforcement of Money Judgements

The successful plaintiff in the civil action will typically obtain a money judgement against the defendant. A judgement is not an order to pay, but declares that the plaintiff shall have recovery of the defendant, the stated sum, and have execution thereof. If the defendant pays, the matter is settled. If the defendant does not pay, the plaintiff must proceed by the process of execution to obtain satisfaction from the defendant’s real and personal property.

A judgement gives the successful plaintiff the right to levy on any of the defendant’s asset that the plaintiff can locate. The judgement often doesn’t require the defendant to even cooperate by disclosing the existence and location of such assets. Execution involves a number of steps and procedures. The details of which vary from state to state.

The basic objectives are to allow the victorious plaintiff:

  1. first to obtain possession of defendant’s assets by legally seizing the assets by attachment, by levy, or by garnishment.
  2. then to conduct a public sale of any non-monetary asset seized. The proceeds of which are used to satisfy the judgement.
  3. If the proceeds from the sale exceed the amount of the judgement, any excess is paid back to the defendant.

Both the seizure and the sale are often undertaken or supervised by representatives of the state. In addition, by docketing of a judgement, a lien can be placed upon the defendant’s non-exempt real property. The lien would be uncovered by perspective buyers and a title search would make it difficult for the defendant to sell the property until the lien have been lifted by paying off the judgment.

There can be many slips between the docketing and satisfaction of a judgment. Nevertheless, unless the claim reduced to judgment is discharged in bankruptcy, the plaintive normally has a 20-year renewable period to obtain satisfaction.

Security Interest

A security interest is an interest in public property which secures payment or performance of an obligation. Under Article IX of the UCC, sellers of goods on credit or other lenders can:

  1. Create (by the security agreement with a buyer or borrower) a security interest in personal property of the borrower.
  2. Then perfect it by filing a finance statement in the appropriate public office.

The agreement creating the security interest, called the security agreement is often accompanied by a negotiable promissory note that evidences the debtor’s obligation to pay. A creditor takes a security interest in particular pieces of property, not in the debtor’s entire estate. The main advantage of a security interest is speed, because due process takes time. The ability to privately take possession without delay or legal expense is the key benefit of a security interest.

Due processA plaintiff with an unsecured civil claim (arising out of contract or tort):
1. need to serve the defendant notice of the suit
2. wait for an answer and proceed through discovery
3. wait for trial
4. obtain the judgement after trial
5. hire a sheriff to levy on the defendant’s property.
Security interestA security interest holder can skip the filing and privately levy on the property without a trial, upon default by the debtor on the note or as defined in the security agreement.

Property Rules and Liability Rules

Legal entitlements tend to be protected in one of two distinctive ways:

Property rulesStrong.
Attempt to deter third parties from non-consentually taking the entitlement.
Designed for deterrence of potential takers.
More efficient when transaction cost is low.
Force takers to use market contracts when they can.
Liability rulesWeaker.
Attempt to compensate an entitlement holder for the loss of an entitlement that is non-consensually taken.
Designed for compensation of potential takees.
More efficient when transaction cost is high.
Allow takers to mimic the market when the takers can’t use the market.

Most areas of law including property and tort law, have deployed mixtures of property and liability rules with regard to particular legal entitlements๏ผš

  1. Sometimes, the extent of protection will turn on who is doing the taking.
    • Home is protected by a property rule, say criminal trespass, with regard to taking by a private citizen.
    • Home is protected by a liability rule, say the Constitution’s takings clause guarantee of just compensation, with regard to taking by the government.
  2. Sometimes, the extent to property protection turns on how the taking occurred.
    • Intentionally taking a car โ†’ criminal law sends you to jail.
    • Negligently destroy a car โ†’ tort law says you have to compensate the owner.

Contractual Entitlements

If the parties had a sufficient opportunity to contract, Calabresi and Melamed’s theory would suggest the property protection is more appropriate. How should contractual right be protected? Calabresi and Melamed’s theory might also suggest that contractual entitlements should be protected by property rules. After all, the parties were able to contract initially.

But contractual law normally does not protect contractual entitlements with specific performance. It doesn’t normally use property rule protections, instead, the normal remedy is a liability rule protection. But still there are several instances where contractual entitlements are protected by property rules.

You don’t really know the value of an entitlement until you know how it’s protected.

Substantial Performance Rule

A party to a contract can help secure her right to the other side’s performance by:

  • either withholding her own performance (defensive)
  • or affirmatively suing the other side for damages (offensive)

The case Jacob & Youngs v. Kent is often taught in introductory contracts courses because it touches on several important issues. The case illustrates many important principles in contract law. There are two main issues:

The defensive issueWas the installation of Reading pipe a constructive condition to the owner’s duty to pay the last installation due, or were “the promises to pay” and “the promise to install Reading pipe” independent?
The offensive issueWhat kind of remedies are appropriate for the builder’s breach?
Is the measure of damage for a breach (by the builder) “the cost of performance” or “diminution in value”?

To solve the issues above, there are a few rules for “duty to pay”, the judge Cardozo refused to use the Perfect tender rule and the Independent promises rule. Cardozo crafts an intermediate standard: the Substantial performance rule.

Perfect tender ruleThe buyer would have no duty to pay unless the builder’s performance was perfect.
Substantial performance ruleSome promises, “though dependent and thus conditions, when there is a departure in point of substance”, will be viewed as independent and collateral when departure is insignificant.
“Where a breach is trivial and innocent, a breach may be atoned for by allowance of the resulting damage.”
Independent promises ruleIf the buyers promise to pay is deemed to be an independent promise of the builder’s promise to build, then the buyer has an unconditional contractual duty to pay regardless of the builder’s performance.

The substantial performance rule resolves both the defensive and offensive issues.

The Defensive Issue

The substantial performance rule has two prongs:

  1. Willful breach
    • helps assure that the builder will not intentionally chisel on her promise to build.
  2. Less than substantial performance
    • helps assure that the buyer will not refuse to pay for trivial breaches.

In this case, the court found that the plaintiffs substantially performed its side of the contract, where a breach is trivial and innocent, and may be atoned for by allowance of just resulting damages. This substantial performance rule resolves the defensive rights issue in favor of the builder. Because the plaintiff installed a pipe equal in price and quality to Reading Pipe, the court found that the plaintiff substantially performed his side of the contract, and was not in material breach. 

What counts as substantial performance? It is determined by considerations partly of justice and partly of presumed intention. Substantial performance rule is a middle ground between perfect tender and Independent promises (unconditional duties to perform), minimizing both seller and buyer opportunism.

Future parties can contract around the substantial performance rule. A buyer with idiosyncratic preferences can request perfect tender by revealing their preference explicitly in the contract. Putting the onus on the buyer makes sense from an economic perspective, because the idiosyncratic buyer is the least cost avoider. It’s cheaper for the buyer to speak up than for the seller to speculate about all the possible idiosyncrasies.

The Offensive Issue

As for damages, the defendant is only entitled to diminution in value and not the cost of performance.

The court held that when breaches not willful and the cost to replace the pipe is high, the defendant is only entitled to diminution in value damages, which in this case is nothing. The diminution in value is nothing because the pipes actually installed are equal in quality and value to the Reading Pipe that was promised.

In this case, the cost of performant damages does not mean that construction company would have had to tear out the wall and replace the pipes. The construction company can pay the buyer money to be let out of its duty to perform. The incentive to modify the contract in the presence of cost of performance damages, is an example of Coasian bargaining.

The Coase theorem is a highly influential, legal, and economic theory. It states that where transaction costs are low, an efficient allocation of resources will take place regardless of how entitlements are allocated. Here, there’s a Coasian incentive for the seller to buy her way out of her “duty to sell” to the original buyer.

Seller’s Duty to Sell

A buyer’s duty to pay is nominally conditioned on the seller substantial performance. On the other hand, a seller’s duty to sell is normally conditioned on perfect tender or full payment.

Contractual Damage Remedies

There are three main interests that contract damages protect. Judicial remedies serve to protect one or more of the following interests of a promisee:

Expectation interestHis / her interest in having the benefit of his / her bargain by being put in as good a position as he / she would have been in, had the contract been performed.
Reliance interestHis / her interest in being reimbursed for loss caused by reliance on the contract by being put in as good a position as he / she would have been in, had the contract not been made.
Restitution interestHis / her interest in having restored to him / her any benefit that he / she has conferred on the other party.

The general rule is that plaintiffs can choose which of the three damage measures they want to pursue in contractual breach cases.

Expectation Interest

Expectation interest is the one that is most commonly awarded as damages in contract law. When a court awards a plaintiff expectation damages, it tries to put the plaintiff in as good a position as she would have been in, had the defendant perform the contract as promised.

To assess expectation damages, we have to compare:

  • the position of the plaintiff that the plaintiff would have been in if the defendant had perfectly performed his promise, with
  • the position we find the plaintiff in now.

The idea is that when one party breaches the contract, he has no right to worsen the other parties relative position to what it would have been if the contract had been performed. In law and economics, this principle is connected to the idea of efficient breach. A party should breach a contract only when he receives benefits from doing so, that are enough to compensate the other party for her losses from the breach.

Reliance Interest

When a worrying reliance damages, the goal is to put the plaintiffs back in the position she occupied just before the parties entered in upon the agreement. To assess reliance damages we have to compare:

  • the plaintiff’s position just before entering with the contract, with
  • the position we find her in now.

It’s worth noticing that in some situations the difference between expectation and reliance damages vanishes.

Restitution Interest

The restitution interest, the third measure of damages, is discussed less frequently and is concerned with ensuring that the party that has breached a contract doesn’t get to keep the benefits he or she received from the contract.

While expectation and reliance focus on the plaintiff’s positions, restitution focuses on the defendant’s positions. The more standard type of restitution attempts to put the defendant in the position he or she would have been in had the contract not been made. It thus compares:

  • the position we find the defendant in, with
  • the position the defendant was in, just before making the contract.

The Coarse Theorem

The Coase Theorem holds that in a world without transaction costs, the choice of legal rules does not affect efficiency because private parties would always bargain their way to optimal behavior. Coase’s famous example concerns the potential of railroad train sparks to cause fires to adjoining farmland.

Before Coase, lawmakers believed that in deciding whether to hold railroads liable for crop damages, the law would be influencing the amount of precaution taken by both railroads and by farmers. In the absence of bargaining:

  • If the law held railroads responsible for any fire damage losses to farmers crops, one would expect railroads to take more precautions (for example, by adding spark guards to their trains).
  • If the law held that the farmers had to bear any fire damage losses that occurred to their own crops, one would expect farmers to take more precaution (for example, by planting their crops further away from the railroad tracks).

Coase deduced that the law need not influence the precaution taking. In a world without transaction costs, the parties will have a mutual incentive to agree to have each expend the efficient level of precaution. In a world without transaction costs:

  • If the law holds railroad strictly liable for all fire losses, the railroad will pay farmers to take the appropriate amount of precaution.
  • If the law holds railroads blameless for any crop losses, then Coasian contracting will lead farmers to pay the railroad to take the efficient level of precaution.

The choice among different legal standards for liability will not impact the levels of precaution taken by the railroads and by farmers. The legal standards will only impact the distribution of wealth as the background legal rules will often determine who pays whom.

Allocation Invariance, Efficiency Invariance

The theorem holds that, in the absence of transaction costs, the assignment of legal rights will not impact the ultimate allocation of rights. Rights flow to their highest use and rights would be efficiently allocated.

Distributional Variance

But the assignment of rights will impact the distribution of income because if the most efficient owner is not initially assigned a right, he or she will have to pay for it.

Just as the assumption of frictionless motion has proven to be a useful construct for physics, the assumption of frictionless contracting allowed Coase to analyze the effect of unimpeded bargaining in the shadow of the law.

With unimpeded bargaining, different legal rules will not influence allocative efficiency. They’ll only have distributional effects.

Implications for Contract Law

The Coase Theorem has also interesting implications for contract law.

Oliver Wendell Holmes Junior famously re-oriented contract law toward a dyadic conception of contractual duties. For Holmes, a contractual promise was not a sacred duty that simply had to be performed, rather a contractual promise was merely the duty either to perform or pay compensatory damages.

But the Coase Theorem invites a triadic conception of promise. Following Coase, we might see a promise as:

  1. a duty to perform
  2. pay damages, or
  3. renegotiate your way out of performance.

The Coase Theorem suggests that we don’t have to worry about too few breaches when damages are high, because promises will bribe their way out of having to perform an inefficient promise. Similarly we don’t have to worry about too many breaches when damages are low.

The Coase Theorem has even stronger implications with regard to the laws choice among different possible default rules, for example: at-will employment and just-cause employment. The Coase Theorem suggests that the law will impact neither allocative efficiency nor the distribution of wealth. In a world with costless contracting, the employer and employee will contract for the efficient level of protection that maximizes their joint gains regardless of the default rule. Regardless of the default rule, the parties will contract for the same salary.

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