Two Views of Contract Law

Gerard Magliocca

Gerard N. Magliocca is the Samuel R. Rosen Professor at the Indiana University Robert H. McKinney School of Law. Professor Magliocca is the author of three books and over twenty articles on constitutional law and intellectual property. He received his undergraduate degree from Stanford, his law degree from Yale, and joined the faculty after two years as an attorney at Covington and Burling and one year as a law clerk for Judge Guido Calabresi on the United States Court of Appeals for the Second Circuit. Professor Magliocca has received the Best New Professor Award and the Black Cane (Most Outstanding Professor) from the student body, and in 2008 held the Fulbright-Dow Distinguished Research Chair of the Roosevelt Study Center in Middelburg, The Netherlands. He was elected to the American Law Institute (ALI) in 2013.

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16 Responses

  1. WPB says:

    Charles Fried wrote a book 29 years ago, called Contract as Promise, laying out the second view. My sense is that there are plenty of others who have followed in the same vein.

  2. Jeff Lipshaw says:

    There’s extensive work on this, Gerard. Seana Shiffrin (UCLA) wrote an article in the Harvard Law Review a couple years ago called The Divergence of Promise and Contract. Roy Kreitner (Tel Aviv) writes on this. Daniel Markovits (Yale). Jody Kraus (Virginia). Nathan Oman (William & Mary, your blog partner). And . . . I write on this.

    If you haven’t heard, we are hosting a one day symposium at Suffolk University Law School in Boston on Friday, March 25, 2011 entitled “Contract as Promise at 30: The Future of Contract Theory.” All the people noted above and more (Richard Posner, Richard Craswell, Lisa Bernstein, Barbara Fried, e.g.) will be there.

  3. Ken Rhodes says:

    Gerard, you wrote: “What, if anything, do contract scholars have to say about this?”

    You might get a very different answer if you asked what ethics scholars have to say. Not because they see “contracts” differently from legal scholars, but rather, because they see a mortgage as different from simply a contract to perform.

    Instead, the ethical conundrum is the word “borrow.” From early childhood, we are taught (and generally believe for the rest of our lives) that if we borrow something, we have to return it. If the “something” is a tool, or a baseball glove, or a car, we have to return it in approximately the same condition as when we borrowed it. And in any case, including money, we not only have an obligation to return it, but we have to do so “on time,” i.e., when we promised we would.

    The guilt we feel when we fail to return something we borrowed has nothing to do with a contract we signed, and if we make a sound business decision to walk away from the contract, we are probably going to carry that weight for a long time.

  4. Gerard Magliocca says:

    This is great. You can always learn something new.

  5. Meredith R. Miller says:

    I actually have an article forthcoming in the Cornell Real Estate Journal on this exact topic. It is titled Strategic Default: The Popularization of a Debate among Contract Scholars. Interestingly, the public discourse has mirrored the academic debate between efficiency and morality. Happy to share a draft with anyone who is interested.

  6. Logan Roise says:

    I think an interesting comparison would be to look at attitudes toward car loans visa versa home loans. Most all of us take out a car loan when we get a new vehichle yet we all know that said vehichle will be worth significantly less than the loan amount the minute we drive it off the lot. With home loans, however, we assume our property will increase in value. So maybe it is the assumption that our homes will increase in value that is the problem.

  7. A.J. Sutter says:

    “Indeed, the theory of efficient breach holds that society will be better off in many instances …”: this illuminates another aspect of the paradox — economic “efficiency” itself takes on moral overtones. That’s not to say that no one would have recognized “strategic default” as an option: California’s “one-action rule” antedates the rise of L&E. But the normative judgment that a mathematical property like efficiency is also a morally desirable thing may make the analysis more perplexing to a modern jurist.

    According to the website of Santa Clara U. law prof Gary Neustadter (apparently quoting from commentary in his 1996 casebook on secured debt):

    “The case law on [Cal. Code Civ. Pro.] section 726 suggests that it serves several purposes: (1) it fulfills a debtor’s expectation that personal liability is conditioned upon the creditor’s prior recourse to the collateral; (2) it minimizes the debtor’s exposure to personal liability by testing the value of the collateral in the market place; (3) it prevents the debtor’s exposure to a multiplicity of actions; and, (4) it at least temporarily preserves unencumbered assets of the debtor which the debtor may need for other purposes, including to finance a defense to a foreclosure action. We present four cases that articulate these purposes of section 726 in reaching conclusions about the applicability of the section in a variety of factual circumstances: Savings Bank v. Central Market Co. (the sold-out junior); Pacific Valley Bank v. Schwenke (the effect of one debtor’s waiver of section 726 on a co-debtor); Security Pacific National Bank v. Wozab (the effect of set-off by the secured party); and Shin v. Superior Court (the effect of pre-judgment attachment).”

    Note the first of these justifications, that the rule was to protect a debtor’s expectation — maybe the flip-side of the “contract as promise” point of view today.

  8. Lawrence Cunningham says:

    The debate doesn’t matter to the borrower considering whether to default or not because there is no gain from breaching: the damages are the principal and interest promised to be paid. Performing the promise and breaching the promise mean the same result.

    A breach is efficient (Pareto optimal) only if by breaching the breaching party achieves a gain, can compenstate the aggrieved in party in full, captures some net gain, and no one else is worse off. But there’s no gain from breaching an obligation to repay money borrowed.

    In addition, even when breaching is efficient in that sense, actual law doesn’t care if a breach is efficient or not. Other than a handful of judges, led by Richard Posner, contract law is indifferent to whether a breach is efficient or not. The efficient breacher is in no better or worse legal position than the inefficient breacher.

    Real people don’t actually think in the terms described by economic theories of contract breach either, despite what some first year law students might be misled into thinking. Recent work by fellow Co-Op blogger Dave Hoffman and Penn Law Professor Tess Wilkenson-Ryan are demonstrating this point in robust and important ways.

  9. Matt Lister says:

    I, too, was going to suggest looking at Tess Wilkinson-Ryan’s work, both with Hoffman and some things she’s working on now just on this subject. It’s more descriptive as to how people think about the subject than normative (like the work of Fried, Shiffrin, etc. mentioned above) but it’s very interesting and important stuff, done in a sophisticated way.

  10. Tess Wilkinson-Ryan says:

    Thanks, Matt and Larry! I think there is very good evidence that many people do hold a contract-is-promise view of their mortgages, and that it may indeed prevent them from walking away when it is otherwise cheaper to do so. I have been writing a paper about the moral psychology of strategic default, and it was partly inspired by a blog post, actually, on Freakonomics. If you look at the comments to this post: http://freakonomics.blogs.nytimes.com/2009/02/09/our-daily-bleg-a-real-estate-dilemma/, you can see commenters explicitly struggling with how to define their moral obligations in contract. There are a number of interesting factors that seem to affect their attitudes (which I ultimately tried to test more systematically, but you can see them just by looking at the comments), including judgment of the bank’s own moral culpability, the relationship with the lender, and the sense that walking away has become so prevalent that only suckers would keep paying.

  11. A.J. Sutter says:

    Overheard from The Magnificent 7 (1960), aired last night on satellite TV in Japan: The lead gunslingers, played by Yul Brynner and Steve McQueen, are debating whether to leave the Mexican village they have come to protect, due to growing hostility from some of the village men:

    Brynner: You forget, we took a contract.
    McQueen: It’s not the kind any court would enforce.
    Brynner: It’s just the kind you keep.

  12. Lawrence Cunningham says:

    Nice quote Andy!

  13. Meredith R. Miller says:

    I’ve posted a draft of the article (mentioned above) to SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1685467

    Meredith

  14. Lawrence Cunningham says:

    Meredith (13): Nice paper. Can you help me with a general query:

    Is it true that in all cases every foreclosure remedy discharges a borrower’s further obligation to repay the remaining loan balance? I see from footnote 54 that 11 states have statutes making foreclosure the sole recourse; it also says that even when lenders have the continuing right to recover the deficiency, they don’t often pursue it.

    But except when state law (applicable in 11 states) or the contract bars recovering the deficency, doesn’t the borrower still owe the balance, whether they “walk away” or not? If so, in those cases, is the effiency-morality issue even implicated?

    Thanks for any clarification you can bring to my hazy understanding of this.

  15. Meredith R Miller says:

    Lawrence-

    Where there is no statutory or contractual bar, a lender may seek a deficiency judgment (difference between price in foreclosure sale and remaining outstanding balance). In those situations, the incentive to walk away is not as strong because of the possibility of having to pay up the deficiency. However, if lenders do not usually pursue this right, it may be worth it to walk away and risk such a judgment. In that sense, I think the efficiency-morality issue is still implicated, but it is certainly more squarely in issue where the lender has no right beyond foreclosure.

    Meredith

  16. Nate Oman says:

    I’m coming late to this but Curtis Bridgeman at FSU has a paper that I recently heard workshopped analyzing the morality of so-called jingle mail.

    I would point out that one can reconcile the two views if you see contracts as containing — as a matter of choice and self-imposed moral obligation — an embedded option. Seanna Shiffrin has pooh-poohed this view, but I think that her argument proceeds too fast and isn’t sufficiently attentive to context.

    I for one am genuinely puzzled as to whether I should regard a non-recourse mortgage as a promise to pay with a limited penalty or as a choice between purchase and a put option. This is different than the efficient breach argument, but rather hinges on how I should understand the obligations undertaken in the contract.