Fresno Lawyer – Randolf Krbechek

Professor Brent T. White from The University of Arizona Law School has followed up his report issued last fall regarding troubled loans.  Prof. White personally communicated with more than 350 individuals regarding their mortgage problems.

His new report raises a number of troubling issues, but none more so than the dissembling tactics of lenders.

Writes Prof. White, “The reason that many strategic defaulters struggle so long before deciding to default is that fear and anxiety are not typically enough in isolation to cause them to stop making payments.  Rather such anxiety more frequently serves as a call to action, driving homeowners to try to do something about their situation – such as contacting their lender to try to work out a loan modification or a short sale.

“In fact, not a single strategic defaulter in the 356 accounts reviewed for this article reported having stopped paying their mortgages without first contacting their lender . . . Many underwater homeowners who seek help from their lenders, however, are turned away at the door. As one homeowner explains, ‘I called my lender and ask if I could discuss a loan modification and they said absolutely not.’  Lenders give numerous reasons for this, most commonly that homeowners are current on their mortgages.”

If you are current on your loan, regardless of the financial struggles to maintain the loan, you will never get your loan modified.  “The fact being a ‘responsible’ borrower is the surest way not to get a loan modification can be a rude awakening for many homeowners.”

Prof White continues.  “This is because most lenders don’t modify mortgages or agree to short sales for homeowners who might continue making their payments absent such accommodation. The best predictor that a homeowner will continue making payments is a good credit score and a past history of making their payments.  Homeowners with such characteristics thus have little chance of getting help unless they first miss some payments, and they are frequently told this by the loan servicing personnel who take their calls.”

Worse yet, “The loan modification process turns out, however, to be immensely frustrating[.]   Homeowners are frequently unable to reach anyone to discuss their applications’ status[.]  Their paperwork is ‘lost’ repeatedly[.]  They are treated rudely and lied to[.]  Worse, after months of frustration, most homeowners learn that their lender is not willing to work with them after all.”

Prof. White is not exaggerating.  I have yet to meet a borrower with anything positive to say about the loan modification process.  As a society, we are not serious about helping borrowers with troubled home loans.

Brent T. White, Take this House and Shove it: The Emotional Drivers of Strategic Default (May 2010)

This is an updated report on the status the foreclosure crisis in Fresno County as of June 2010, based on anecdotal evidence.  In a word, it’s brutal for troubled borrowers.

Foreclosures Are Continuing:  There does not seem to be any slowdown in foreclosures.  Lenders buy in for the amount of the unpaid debt, then sell at a slight markup.  The buyer then markets the property for a greater profit.

Example:  A house might sell at foreclosure to the lender for $120,000.  The lender resells the property for $150,000.  The buyer in turn markets and sell the house for $200,000.  All of this takes place within six months.  The original owner takes nothing on the mark up.

Cash is King: Lenders have little risk on foreclosure sales because houses re-sell quickly on all-cash offers.  Evictions follow rapidly after the foreclosure sale, and are sometimes started on the day of the sale.

Securitization Creates Murky Ownership:  Because of the securitization of mortgages, it is extremely difficult to determine who is calling the shots for the lender.  It seems that mortgages have been sold off piecemeal, and the third-party mortgage holders are conducting the foreclosures.  The owner is greatly distanced from the lender, and it is almost impossible to identify the entity that is in control of the mortgage and the foreclosure process.

The Home Affordable Modification Program is a Failure:  This writer has yet to see one mortgage that was modified as a result of the federal Home Affordable Modification Program.  The external evidence on the HAMP program is damning.

Professor Jean Braucher from The University of Arizona Law School explains that “HAMP provided for modification of first-lien mortgage loans originated on or before January 1, 2009, where the loan was secured by a one- to four-unit property, one unit of which was the borrower‘s principal residence.”

In order to qualify for a HAMP modification, “the debtor‘s gross monthly mortgage payment had to exceed 31 percent of gross income [and] the borrower had to document a financial hardship and be delinquent on the loan.”

That would cover a lot of troubled mortgages.  Explains Prof. Braucher, “The goal of HAMP is to create a partnership between the government and private institutions in order to reduce borrowers‘ gross monthly payments to an affordable level. The level has been set at 31 percent of the borrowers‘ gross monthly income.”

However, the rules have never been explained.  “The HAMP [ ] formula was not made public, in part out of concern that doing so would have allowed borrowers to game the calculation, but making it difficult for borrowers and their mortgage counselors to know whether to apply for a modification and to assess denial of an offer.”

Further, the lender bears the costs.  “HAMP made investors responsible in full for the cost of bringing the debtor‘s gross monthly mortgage payment down to 38 percent of gross monthly income.  HAMP also provided for the government to then share equally with investors the further cost of bringing the mortgage payment down to 31 percent of income.”

So, in order for HAMP to work, the lender has to admit it made a bad lending decision, and has to agree to eat part of the loss.  Sadly, given the availability of cash in the housing market, it’s easier for the lender to precipitate a foreclosure sale, then sell the property for the full amount of the loan and all delinquency charges, meaning that the lender is made whole, and the owner absorbs the entire loss.

Notes Prof Braucher, “through September 1, 2009, the Congressional Oversight Panel reported that HAMP, with a goal of avoiding three to four million foreclosures in three years, had achieved only 362,348 three-month trial modifications.  Even more disappointing, the Congressional Oversight Panel reported that the program had achieved only 1,711 permanent modifications through September 1, 2009.”

Thus, the federal loan modification program has been a profound failure.  This writer’s experiences with troubled borrowers have been similar.

Jean Braucher, Humpty Dumpty and the Foreclosure Crisis: Lessons from the Lackluster First Year of the Home Affordable Modification Program (May 2010).

Attorneys Jim Weller and Alan Ytterberg published a recent article discussing an odd hybrid entity – the “private trust company.”  As the authors explain, “Similar to a regulated trust company, an unregulated trust company is an entity formed under state law for the limited purpose of providing trust services to a single family.”

A private trust company is first an entity established under state law.  “Most states that authorize private trust companies allow them to be formed as a corporation or a limited liability company.”  However, “there is no information available to ascertain the number of unregulated trust companies that have been formed in the U.S.”

By way of history, “U.S. Trust Company (est. 1853), Northern Trust (est. 1889), and Bessemer Trust (est. 1907) were originally formed as private trust companies, but today they are known and respected as public trust companies that provide a wide range of fiduciary and trust services.”

A private trust company is a state-chartered institution that is formed to manage assets for wealthy families into the future.  Thus, “it is a state chartered entity that is formed for the express purpose of providing trust and fiduciary services to a single family” and is tied to one or more irrevocable trusts established by the family.

State the authors, “there are a variety of states which promote private trust companies. Most of these states have favorable tax laws, and they have modernized their trust laws.  In that regard, Wyoming, Nevada, South Dakota, and Texas are some of the more popular states where wealthy families are chartering private trust companies.”

States have different requirements for physical presence in the jurisdiction, but the requirements are not difficult to satisfy.  For example, “Licensed family trust companies in Nevada must have at least one officer who is a Nevada resident, a physical office in Nevada, and “a bank account with a state chartered or national bank having a principal or branch offices in Nevada.”

The authors further explain that, “State banking commissioners have less incentive to subject a private trust company to the same regulatory oversight that a public trust company has because there is no public interest to protect.  This distinction is formally recognized in states which permit private trust companies to seek exemption from certain regulatory provisions that apply to trust companies transacting business with the public.”

So, the state sanctions the formation of an entity, accords it the privileges of conducting business and of limited liability, but provides for little if any public or regulatory oversight.  “A private trust company must meet minimum capital requirements in order to exercise the fiduciary powers granted to it by the chartering state.  These capital requirements vary from state to state.  South Dakota has the lowest capital requirement at $200,000.”

The authors add that, “a private trust company must apply for and obtain a charter from the state where it is to be located.  Once the charter is granted, the private trust company is subject to the laws and regulations of that state.  The lone exception is an unregulated trust company which can be formed in Massachusetts, Nevada, Pennsylvania, Virginia, and Wyoming.”

That’s private justice for the very wealthy in America, which is a distressing topic.

It may be time for average persons to stop investing in the stock market.  I’ve been a big believer in the market over the years, and am familiar with the statistics showing how stock market investments have grown over the years.

But the evidence is mounting – and may now be overwhelming – that shows that the big players have rigged the markets.

First, flash trading a.k.a. computerized trading controls the stock market these days.  The stock exchanges TAKE MONEY to allow traders to hitch their computers closer to the computers used by the stock exchange.

The weird gyrations in the market are driven by computerized traders that make a little going up and a little coming down, as long as the trades keep happening.  For example, Goldman Sachs makes most its income from trading.  Trading your stocks.  For its own benefit.

“Goldman made $3.5 billion in profits in just three months.  While it doesn’t break down profits in detail, it does give a broad sense of where its revenues come from. Just $1 billion or 8 percent, came from traditional investment banking.  The biggest slice, 72 percent, came from trading. Morningstar analyst Michael Wong says that trading category covers a wide range of activity.”

“What we do see is a trend which has been developing over the past few decades. Goldman Sachs and the other investment banks are making more money making trades than they do doing the things investment banks traditionally do.”

The part that makes this all crazy is the hidden derivatives market.  As Matt Taibbi recently reported (Rolling Stone – May 26, 2010), “This insane outgrowth of jungle capitalism has spun completely out of control since 2000, when Congress deregulated the derivatives market.  That market is now roughly 100 times bigger than the federal budget and 20 times larger than both the stock market and the GDP.”

Try to get your arms around that point.  The derivatives market is 20 times larger than both the stock market and the GDP.

Gary Gensler, chairman of the Commodity Futures Trading Commission, described the problem as follows at a June 2010 exchanges conference in New York:   “The buyer and seller never meet in a centralized market.   Right now, when Wall Street banks enter into derivatives transactions with their customers, they know how much their last customer paid for the same deal, but that information is not made publicly available.  They benefit from internalizing this information.”

Taibbi also reports that “Five of America’s biggest banks (Goldman, JP Morgan, Bank of America, Morgan Stanley and Citigroup) raked in some $30 billion in over-the-counter derivatives last year.  By some estimates, more than half of JP Morgan’s trading revenue between 2006 and 2008 came from such derivatives.”

That is simply insane unregulated capitalism.  Your 401k account goes into the tank, the stock market experiences unprecedented gyrations, and the big players make money hand over fist, at your expense.

“Imagine a world where there’s no New York Stock Exchange, no NASDAQ or Nikkei: no open exchanges at all, and all stocks traded in the dark. Nobody has a clue how much a share of IBM costs or how many of them are being traded . . . That world exists. It’s called the over-the-counter derivatives market. Five of the country’s biggest banks [ ] account for more than 90 percent of the market, where swaps of all shapes and sizes are traded more or less completely in the dark.”

Congress drafted legislation to bring derivatives out into the open, which the Senate gutted this spring.  Notes Taibbi, “The Senate [functions] as a kind of ongoing negotiation between public sentiment and large financial interests.”

Folks, we are getting clobbered here.  The Wall Street giants don’t want us to make money the old fashioned way in stocks, by buying good companies at a fair price.  They want trades, lots and lots of trades.  And they want derivatives, where they can gamble all day and make lots and lots of money.

Traditional investing look like a bad play until there is fundamental change in the markets.  Derivatives must come out into the open.  America just suffered a “lost decade” in which the market declined over a 10-year period, just like happened previously in Japan.  Your 401k money is a pawn, and we are all losing while the big players just get richer and richer.

Prof. Seana Shiffrin of UCLA Law School tackles the issue of “contract law’s strong traditional bar on punitive damages for intentional, gratuitous breach of contract.”

She jumps right into the fray:  “Morality, I claimed, correctly regards some breaches of promise as morally wrong and as warranting not only compensation but the administration of morality’s punitive remedies, including blame, criticism, recrimination, and avoidance.”

That is a valid point.  There are times when morality must be part of contract law.  States Prof. Shiffrin, “The contract law invokes promise as the fundamental component of a contract but, puzzlingly, does not subject gratuitous breaches of contract (and hence breaches of promise) to the distinctive punitive measures endorsed and administered by law, save when those breaches are also torts.”

The argument continues.  “If the law’s rationale for the bar on punitive damages is that the prospect of punitive damages might discourage efficient breach of contract – I label this the efficient-breach rationale – then the divergence between morality’s response to breach and the law’s response to breach is problematic in ways that morally decent citizens cannot accept.”

“The efficient-breach rationale forwards a justification for a legal doctrine that consists in the claim that barring punitive damages would encourage and facilitate certain breaching behavior.”

“But this behavior is condemned by morality.  To the extent the law adopts and embodies this rationale, it thereby embraces and tries to encourage and facilitate immoral behavior.  Although the law need not enforce morality as such, it is problematic when the law, either directly, or by way of the justifications underlying the law, embraces and encourages immoral action.”

Amen.  It’s about time someone steps up like this.  The law of contracts should not turn a blind eye to contract that is immoral.

Prof Shiffrin concludes that “Citizens, who in a democratic polity must be thought of as partial authors of the law, cannot, in all consistency, accept such laws and their justifications while simultaneously acting and reasoning as moral agents.  The law ought not to be structured or justified in ways that place citizens in such an untenable position: it must accommodate the needs of moral agency even if it need not or should not enforce morality directly.”

(Seana Shiffrin, Could Breach of Contract Be Immoral?, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1551.)

Prof. Stefan Grundmann argues that strict liability is essential to contract law because it enforces an important societal norm – freedom of choice.

According to Prof. Grundmann, “The majority of civil law scholars endorse the idea that the fault principle is ethically well-founded, and some scholars clearly see it as ethically superior to strict liability.  The core argument is the following: A system that grounds damages in fault gives the breaching party more freedom, since he does not have to answer for developments that he could not control.”

The professor bends the opposing argument.  The application of fault to contract law rests on the premise that the society should condemn some acts, to a greater extent than merely enforcing the financial obligations that are established by private contract.

Prof. Grundmann continues.  “In a Kantian tradition, it is seen as an act of freedom to choose between breach or conformity with a contract.  Others, however, argue that a regime of strict liability may also foster some level of freedom by furthering the principle of pacta sunt servanda, that agreements must be kept – a principle of equal importance with freedom of will.  Therefore, balancing of both principles seems necessary.”

Here the professor seeks to balance two moral standards.  He asserts that “freedom and pacta sunt servanda are not of equal importance, at least not in the context discussed here.  There is actually a clear hierarchy between them, and pacta sunt servanda is clearly more important because of the following reason.”

“Those who advocate the ethical superiority of the fault principle because it gives the breaching party the freedom to answer only for those acts and events for which he is responsible forget one rather simple fact: there is an earlier type of freedom that allows each party to decide what offers he makes and to which standards he wants to bind himself, i.e., the freedom of contract.”

Here we get to the heart of the argument – that protection of individual rights is more important than protection of societal norms.  States Prof. Grundmann, “The most vital tenet of freedom in modern times [ ] is the right of each person to decide, to the greatest extent possible, which obligations to assume.  This freedom – which comes first – is disregarded if the question of whether fault or strict liability should govern is decided, not on the basis of the parties’ expressed or implicit intentions, but rather on the basis of an ‘ethical credo’ about the superiority of fault or of strict liability.”

Again, the focus on individual rights ignores the question of whether fault – not as an excuse for breach of contract, but as justification for additional remedies – advances important societal values.

Concludes the author, “strict liability better fosters freedom of contract.”  Thus, “If the freedom of the parties is taken seriously, the question is how to interpret their intentions, not to impose on them a regime judged by scholars, legislatures, or any other third party to foster their freedom and therefore be ethically superior.  Replacing the choice made by the parties – even if justified as fostering freedom – is paternalistic.”

(Stefan Grundmann, The Fault Principle as the Chameleon of Contract Law: A Market Function Approach, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1583.)

Prof. Roy Kreitner of Tel Aviv University shows great insight into the dichotomy between tort and contract law.  He first discusses how tort law shifted toward a fault-based system during the nineteenth century.

States Prof Kreitner, “the early [tort] law asked simply, ‘Did the defendant do the physical act which damaged the plaintiff?’  T[ort] law of today, except in certain cases based upon public policy, asks the further question, ‘Was the act blameworthy?’”

Thus, “the ethical standard of reasonable conduct has replaced the unmoral standard of acting at one’s peril.  It is most likely that theories of strict liability were dominant during the formative years of the common law.  But during the nineteenth century . . . there was a decided and express shift towards the theories of negligence.”

Prof Kreitner continues.  “The accounts of such a shift are persuasive, but only when one acknowledges that the shift took place over the course of decades (rather than, say, through one key judgment of an individual court) and that it solidified quite late in the nineteenth century.”

Further, the shift in tort liability occurred among societal changes.  “The importance of the shift in background assumptions about liability could hardly have been imagined early in the nineteenth century, when the number of serious injuries from industrial activity was minuscule in comparison to what would emerge in the last third of the century.”

“By the last two decades of the nineteenth century, the question of the extent to which injuries from industrial accidents could go uncompensated had become a major economic battleground in ways that would have been difficult to appreciate early in the century.”

Prof Kreitner then turns to contract liability.  As he states, “Everyone is familiar with the idea that contract rests on a species of strict liability, namely the claim that in general “duties imposed by contract are absolute . . . It remains an ingrained aspect of mainstream understandings of contract.”

He explains that, “What generally escapes appreciation is that the understanding of contract as a strict liability regime is anything but an age-old phenomenon.  In fact, such a regime emerged in the United States only at about the same time as the solidification of the no-liability-without-fault regime in tort, during the final decades of the nineteenth century.”

“During the first half of the nineteenth century, although receding slowly in the decades following, contract was understood as a fault-based regime.”  The professor explains that fault was interposed because contracts arose out of relationships.  Contract law “was understood in direct reference to the typical contractual relationships that constituted it.  This world of contract was inhabited by people in relational pairs: bailor and bailee, principal and agent, master and servant, principal and factor, landlord and tenant, vendor and purchaser, husband and wife.”

Given these relationships, “actors had standardized duties, whose contours were shaped by the relation itself.  Individual agreement tailored these duties only on the margins.  And while some of the relations included duties we could characterize as absolute, it was far more typical for duties to be framed in terms of reasonable skill, reasonable diligence, or reasonable care.”

Accordingly, early contract liability was premised on fault.  “It was a failure to meet the standard of care, often phrased directly in terms of negligence, that triggered contractual liability.  Thus, the basic standard of liability was one of fault, even if fault of an objective variety.”

Societally-imposed standards were gradually removed from contract law.  “In order to exclude the state, the theory of contract had to place the parties in full control of the relationship.  Once that was accomplished, the road was open for the parties’ self-imposed obligation to be construed as absolute.”

The shift was societal standards (i.e., liability based on fault) to absolute liability has been complete in contract law for a century.  “Contract was thus established as the very center of the private realm, in part by purging its fault-based standards.  Indeed, it is the image of strict liability that heightens the sense of party control and autonomy, since it is always assumed that the parties could, if they wished, contract for any other standard of liability within their contract.”

Yet, norms of conduct remain part of contract law, which is why concepts of fault have not been eradicated from contract theory.  “Part of what parties to a contract are involved in is the generation of a public good [. ]  This idea should not sound farfetched.  It is intuitive that contracting parties generate a public good in the shape of trust in the market, or the idea of safe contracting.”

“Consider, for example, the difference between analyses of nondisclosure and misrepresentation: when dealing with silence regarding features of the transaction . . . The analysis of misrepresentation is fundamentally different, quintessentially fault based, and obviously reliant on sources outside the parties’ own agreement – and yet, no less contractual for that.  Nondisclosure can theoretically be overcome simply by asking the right question.  Misrepresentation, however, threatens to unravel the basic background trust without which market transactions would be far more difficult.”

(Roy Kreitner, Fault at the Contract-Tort Interface, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1533.)

Professors Robert Cooter and Bradley J. Freedman analyzed the economic character and legal consequences of the fiduciary relationship.  As discussed below, their strongest point is to explain that not all fiduciary duties are the same – it depends on the nature of the relationship.

As a starting point, they acknowledge that “Legal theorists and practitioners have failed to define precisely when such a relationship exists, exactly what constitutes a violation of this relationship, and the legal consequences generated by such a violation . . . In any of these paradigmatic forms, a beneficiary entrusts a fiduciary with control and management of an asset.  Ideally, for the beneficiary, this relationship would be governed by specific rules that dictate how the fiduciary should manage the asset in the beneficiary’s best interests.”

“Because asset management necessarily involves risk and uncertainty, the specific behavior of the fiduciary cannot be dictated in advance.  Moreover, constant monitoring of the fiduciary’s behavior, which would protect the beneficiary, often is prohibitively costly . . . The fiduciary relationship exposes a beneficiary/principal to two distinct types of wrongdoing: first, the fiduciary may misappropriate the principal’s asset or some of its value (an act of malfeasance); and second, the fiduciary may neglect the asset’s management (an act of nonfeasance).”

Employing a law and economics perspective, Cooter and Freedman pose the question: “How can one party be induced to do what is best for another without specifying exactly what is to be done?”

Cooter and Freedman consider how to deter wrongful conduct by the fiduciary.  As they explain, “Once a consensual relationship in which the principal relinquishes control or management of her asset to the agent is formed, the resulting separation of ownership from control or management creates opportunities for the agent to appropriate the asset or some of its value.”

This leads to the first broadly-stated category of wrongful conduct:  misappropriation, or violation of the duty of loyalty.  “Fiduciary law creates a cluster of presumptive rules of conduct compendiously described as the duty of loyalty . . . Taking advantage of these opportunities whether by theft, diversion, conversion, or trespass would violate the agent’s duty of loyalty.”

“Generally, once a fiduciary is shown to have purchased her own asset on behalf of the principal without its consent, either she is held to be disloyal and allowed no defenses, or she has the burden of proving her loyalty.”

The professors suggest that “If the parties to this agreement possessed perfect information, disloyalty could be controlled or prevented by contract.”

In the real world, that is not correct.  It does not matter how much is written into the contract – if the thief wants to commit larceny, the contract won’t stop him.

Even more, the fiduciary relationship is a “relational contract,” in which obligations morph over time.  Cooter and Freedman correctly state that, “In fiduciary relationships, however, the parties are unable to foresee the conditions under which one act produces better results than another.  Rather, chance events and unanticipated contingencies require continual recalculation to determine which course of action will be the most productive.”

This leads into the second category of wrongful conduct, “negligent mismanagement, [which is] is governed by the duty of care.”

Here lies the strongest points in the article.  Cooter and Freedman state that “Judgment especially is important when decisions involve an element of risk.  The duty of care imposes an obligation on the fiduciary to avoid unnecessary risk.”

“However, different levels of risk are appropriate in different fiduciary relationships.  For example, a trustee often is required to be prudent and conservative in managing an asset, whereas a director of a start-up company may be encouraged to take risks.”

That is a point that is ignored far too frequently.  Different relationships lead to different fiduciary obligations, which cannot be painted all with the same brush.

“The bundle of duties and rights created by fiduciary law must be adjusted continually in response to changing circumstances and fresh litigation . . . Holding trustees to higher standards than directors makes economic sense because the same legal rule that imposes a light burden on a trustee would impose onerous restrictions upon a director.”

Thus, Cooter and Freedman conclude that, “Whenever an optimal contract includes fiduciary duties, the economic character of the fiduciary relationship precludes the specification of exact duties . . . The economic character of the fiduciary relationship embodies a deterrence problem for which the duty of loyalty provides a special remedy . . . [To this end] the duty of loyalty must be understood as the law’s attempt to create an incentive structure in which the fiduciary’s self-interest directs her to act in the best interest of the beneficiary.”

Robert Cooter and Bradley J. Freedman, The Fiduciary Relationship: Its Economic Character and Legal Consequences, in 66 New York University Law Rev. 1045 (1991).

This week we consider another view on the issue of whether some contractual breaches are such that additional remedies should be imposed by the courts, beyond the traditional damages for breach of contract.

In other words, Is some conduct sufficiently wrongful that a court should have the right to impose additional damages to deter such wrongful acts?  The law of fiduciary duties answers “Yes – courts should award additional damages by way of deterrence.”  Does this analysis hold weight in a contractual setting?

Professors Steve Thel and Peter Siegelman state that, in the context of a contractual breach, “Willfulness matters [ ] because it identifies those breaches that should be prevented or deterred – that is, all breaches that could have been avoided at little or no cost to the promisor.”

Now, I agree that wilfulness matters, but I believe that the reason why is tied to the relationship between the parties.  Thel and Siegelman instead posit that “when willfulness [ ] is present, courts rightly award remedies that serve to deprive the promisor of any incentive to breach and to assure the promisee of getting full expectation.”  Thus, they tie “deterrence damages” to the relative ease by which a party could have avoided breach.

Professors Thel and Siegelman acknowledge that “contract law generally does not concern itself with the morality of breach in any direct way.  People enter into contracts in hopes that the promises made to them will be kept, and when a promise is broken, the promisee’s injury is typically the same whatever the reason for the breach.  A disappointed promisee ought to be satisfied with full expectation, regardless of what motivated the breach.”

Good point, and an analysis often relied upon by judges.  However, “while contracting parties will agree upon different levels of commitment in different situations, they will almost always agree that some breaches are out of bounds.”

That’s the $64 question.  What kinds of breach fall outside of societal norms?  I think that looking at the conduct inherent in the breach can lead to inconsistent results.  Contract law is, after all, greatly concerned with consistency.  In my view, certain kinds of contractual relationship lead to greater reliance by one of the parties, and therefore the law should impose a higher standard of duty on the breaching party.  This is similar to the concept applied to fiduciaries.

Professors Thel and Siegelman work from a well-known case involving a construction project in which the contractor failed to use the materials specified by the contract.  “Imagine a variant in which the contract calls for Reading pipe, but the builder deliberately substitutes Cohoes, which is cheaper (but just as good), with the intent of keeping the savings.  Should this be treated as a willful breach?  We suggest that it should be.”

Why?  In my view, the reason why is because the property owner placed additional reliance on the contractor and could not defend himself.  According to Thel and Siegelman, ”since the two brands are of identical quality, both builder and owner could be made better off by a breach that substitutes cheaper Cohoes for more-expensive Reading and splits the savings between the two parties . . . That would provide the appropriate party with incentives to look for cheaper materials, and would result in lower contract price.”

Yet, the cost of policing the behavior of the breaching party rises dramatically, and places an undue burden on the property owner.  State Thel and Siegelman, “the problem, of course, is that a builder will have an incentive to substitute not just cheaper but functionally identical materials, but also cheaper inferior ones.”

In a 1906 case, Justice Cardozo wrote that “There is no general license to install whatever, in the builder’s judgment, may be regarded as ‘just as good’.”   Similarly, the court in Groves v. John Wunder Co. explained that “defendant’s breach . . . was wilful.  There was nothing of good faith about it.  Hence, that the decision below handsomely rewards bad faith and deliberate breach of contract is obvious.  That is not allowable.”

Professors Thel and Siegelman conclude that “this is especially true in a construction contract, where such substitute materials are easy to find and substitutions are often difficult to detect.  In the face of this problem, treating the breach as willful and awarding the owner the cost-of-correction measure provides the appropriate incentives for the builder to inform the owner of the opportunity for savings, and to negotiate for consent to deviate from the contract.”

Yet, I think the argument is better cast in terms of the relationship between the parties.  A building owner places substantial reliance on the contractor.  The law should support such reliance, which is the reason why extra-contractual damages should be awarded for wilful breach.

(Steve Thel and Peter Siegelman, Willfulness Versus Expectation: A Promisor-Based Defense of Willful Breach Doctrine, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1517.)

Let’s continue the discussion regarding rules of fault in contract law.  This series is from a law review article written by Professor George M. Cohen, who first notes that:

“The economic justification starts from the same premise as the traditionalist justification – that courts should enforce agreements according to the parties’ mutual intentions.  [Thus,] the strict liability paradigm permeates classical contract law.  Usually, however, the explicit label ‘strict liability’ appears only in connection with the doctrines of performance and breach.”

Prof Cohen is absolutely correct on this count.  Considering the three time frames in a contract – formation, performance, and breach – issues of “fault” really make sense only in connection with performance and breach.

Prof. Cohen continues.  “Under these doctrines, failure in any way to perform a contract breaches the contract, and subjects the breaching party to liability, regardless of fault.  The paradigmatic case is a seller who delivers goods that fail in any respect to conform to the contract.”

“An aggrieved party who can prove breach is entitled to compensation, which contract law generally defines as protecting the expectation interest.  In short, the reason for nonperformance does not matter.”

Yet, in contract law, sometimes it does.  It can depend on the relationship of the parties.  “A traditionalist justification of strict liability must defend the proposition that the parties generally intend that the reason for nonperformance does not matter.  That proposition is, however, contestable, as discussed below.”

Prof. Cohen wants to look to intent, not to the relationship of the parties.  He explains that, “Under both the traditionalist and economic justifications, the argument for strict liability is stronger if mutual intent is easily determined and clearly distinguishable from fault.”

He warns that, “Adopting a fault-based system of contract law in those circumstances would lead to illegitimate social judgments by courts on the traditionalist view, and result in inefficient contracting around or failures to contract on the economic view.”

When, then should fault be considered?  “Determining disputed mutual intent is inherently uncertain.  Mutual intent is an ideal.  Contracting parties attempt to express mutual intent, often in writing, but do so imperfectly.  Contracts are largely a set of private rules, and all rules require interpretation, stories that explain their meaning in a particular situation.”

Now we return to relationships and their unfair exploitation.  “As unanticipated situations arise, disputes requiring interpretation inevitably occur.  The objective theory presumes that when one party manifests some intent and then later asserts a different intent, either he negligently or intentionally misled the other party originally, or is acting opportunistically now.”

Here follows a tremendous observation.  “Parties generally resolve these disputes on their own, often driven by reputational concerns.  When these efforts fail, they bring their disputes to court.  In litigated cases, the parties typically contest the requirements of mutual intent . . . But the uncertainty of intent blurs this dichotomy.  When intent is uncertain, fault can help inform intent in a variety of ways.  Most obviously, parties may expressly use fault concepts in their contracts, such as best efforts and good faith clauses, which essentially invite courts to make fault-based judgments in the event of a dispute.”

Prof. Cohen concludes by noting that, “With respect to contract damages, I have previously argued that the choice among different measures of damages (expectation, reliance, and restitution), as well as the limitations on expectation damages, are best understood as doctrines enabling courts to make relative fault assessments.  In fact, damages doctrines are best suited to dividing liability when both parties are at fault.  In light of this crucial role of damages in facilitating relative fault assessments, the resistance of courts to ‘penalty clauses,’ which preclude such assessments, is eminently sensible, despite the continued objection of many economic scholars.”

(George M. Cohen, The Fault that Lies Within Our Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1445.)