Louis K. Bonham, counsel to the defendant, has done so.  He reports that the case has now been dismissed – but for want of personal jurisdiction.  According to the docket, Judge Miller’s decision issued on October 23.  It rests on the observation that the only contact that the defendant had with Texas was the airing of [...]]]> I’ve  posted on a lawsuit out of Texas, in which a law student plaintiff sued a lawyer defendant for failing to live up to a “promise” to pay $1,000,000 to any television viewer who could prove him wrong about his theory of a case.  I opined the case was a classic example of puffery, unlikely to reach the merits on that ground.   I challenged readers to prove me wrong.

Louis K. Bonham, counsel to the defendant, has done so.  He reports that the case has now been dismissed – but for want of personal jurisdiction.  According to the docket, Judge Miller’s decision issued on October 23.  It rests on the observation that the only contact that the defendant had with Texas was the airing of a television broadcast: personal jurisdiction on these grounds would make him subject to national jurisdiction where it wasn’t otherwise anticipated.

Incidentally, the underlying motion documents suggest that plaintiff’s claim was even weaker on the merits than I’d argued, as the unedited transcript of of the boast is different than the version in the complaint.  Here’s what plaintiff asserted was said:

NBC’s Ann Curry asked whether there was enough time for [Mason's client] to commit [a crime]. An unidentified person said, “The defense says no.”

“I challenge anybody to show me,” Mason said. “I’ll pay them a million dollars if they can do it.”

But here’s what was actually said:

… And from there to be on the videotape in 28 minutes. Not possible. Not possible. I challenge anybody to show me, and guess what? Did they bring in any evidence to say that somebody made that route, did so? State’s burden of proof. If they can do it, I’ll challenge ‘em. I’ll pay them a million dollars if they can do it.

NBC Transcript, p. 3

This kind of qualifying language makes it even more obvious that the statement was a mere puff. Congrats to Mr. Bonham on his win!

It did so, however, in an opinion void of any analysis of the lower court opinions. As to the lost profits claim, in particular, the Court of Appeals merely said it agreed with the lower courts that the assertion was “speculative.” It did not explain why and did not confront or correct [...]]]> As I predicted last month, the New York Court of Appeals last week reversed an Appellate Division decision denying any damages to buyers of real property from sellers who admitted breach of contract to purchase and sell real property. The Appellate Division had denied sought damages measured by lost profits, the contract-market differential and reliance expenses. The Court of Appeals agreed as to lost profits and contract-market differential but reversed as to reliance expenses.

It did so, however, in an opinion void of any analysis of the lower court opinions. As to the lost profits claim, in particular, the Court of Appeals merely said it agreed with the lower courts that the assertion was “speculative.” It did not explain why and did not confront or correct patently erroneous statements in those opinions that the buyers could not recover because they were pursuing a new business enterprise.  More responsibly, though still without analysis, the Court rejected the contract-market claim, by referencing evidence showing that the property value at breach did not exceed the contract price.

Most important, on the reliance branch, the Court of Appeals reversed the lower court rulings that simply failed to see that reliance damages are a standard alternative to expectancy damages (whether lost profits or the contract-market differential), especially when the latter cannot be determined with reasonable certainty.  The Court cited Section 349 of the Restatement (Second) of Contracts, and numerous New York Court of Appeals cases, including the classic Freund v. Washington Square Press, all of which allow recovery of reliance losses incurred in preparing to perform a contract, so long as these are foreseeable and ascertainable.

But what of those incorrect lower court statements about lost profits?  Should the Court not have addressed them?   Affirming by saying it agreed that the lost profits claim was ”speculative” does not exactly reject erroneous statements in the lower court opinion, such as that new businesses face a different burden or hurdle in recovering lost profits.    Reversal as to reliance damages does not disturb them.   While I concur with the Court on all its results in all three damages holdings, does it promote judicial economy to leave clearly erroneous lower court statements about a recurring issue in contract law uncorrected?

When Does This Get Pierced?

If you’ve made it through the content of complaints, some data about who gets sued, and descriptive statistics about wins and losses, you basically are pot committed to this veil piercing project. In this post, I’m going to exploit that commitment by describing the results of our statistical analysis of two different kinds of success that plaintiffs may achieve in veil piercing cases: (1) on motions; and (2) at the case level. If you don’t care to follow me beyond the jump, here’s the bottom line (from our abstract):

“Voluntary creditor causes of action promote veil piercing; LLCs are in very limited circumstances better insulated from veil piercing claims than corporations; undercapitalization is strongly associated with success while conclusory grounds like [...]]]>

When Does This Get Pierced?

If you’ve made it through the content of complaints, some data about who gets sued, and descriptive statistics about wins and losses, you basically are pot committed to this veil piercing project. In this post, I’m going to exploit that commitment by describing the results of our statistical analysis of two different kinds of success that plaintiffs may achieve in veil piercing cases: (1) on motions; and (2) at the case level. If you don’t care to follow me beyond the jump, here’s the bottom line (from our abstract):

“Voluntary creditor causes of action promote veil piercing; LLCs are in very limited circumstances better insulated from veil piercing claims than corporations; undercapitalization is strongly associated with success while conclusory grounds like “façade” and “sham” are not; and defendants’ legal sophistication is predictive of plaintiff failure. Extra-legal factors play a more striking and counterintuitive role. Plaintiffs suing companies with few employees are much more likely to win veil piercing motions, and obtain relief in cases, than plaintiffs suing companies employing many workers. This results holds even when controlling for legally-relevant variables. Contrary to both theory and previous empirical work, we also find that judicial liberalism is inversely related to the likelihood of plaintiff success.”

Veil Piercing Motions

Let’s start with the motions level. We ran a logistic regression, where the dependant variable is plaintiff succeeding at the motions level – - either advancing the veil piercing case (e.g., getting VP discovery), or actually winning – - and a number of our variables of interest reach statistical significance (at p ≤ 0.05 (two-tailed)), including judge ideology, defendant firm size, voluntary creditor-based causes of action, and the presence of the shell, façade, and undercapitalization grounds for piercing in the complaint.* Generally, and in accord with our theory, we get much better model performance when we look at motions-level success than at case-level success.

What does this mean?  Well, consider the effect of being a veil piercing target with more (or less) employees.  For example, the figure indicates that the probability of successfully asserting a veil piercing motion against companies with less than 300 employees being is around 0.80. For companies with more than 2100 employees, that number drops below 0.20.  These results hold when controlling for variables like “being an LLC, or not”, “being incorporated in Delaware, or not”, asserting “informalities as a ground in the complaint, or not”, etc.

By contrast, we find that as a judge’s ideology moves in a conservative direction, the mean likelihood of having successful interstitial veil piercing activity increases.  Motions in cases with very liberal judges have a mean predicted probability of being successful of under 50%, while that probability is around 75% for moderate district court judges and near 95%  for conservative district court judges.  This is, in a word, surprising!

Discrete factors also correlate with success on veil piercing motions.

The bottom portion of the figure to the left contains the plots for the substantive effect of the three veil piercing grounds (in complaints) that have a statistically significant effect on veil piercing motion success: shell, façade, and failure to adequately capitalize (or undercapitalization).  The addition of façade and shell grounds to a veil piercing complaint each provide strong negative effects on the likelihood of veil piercing motions in that case, with a shell ground decreasing the likelihood of veil piercing motion success by over 39%, on average, and a façade ground doing the same by nearly 53%, on average.  Stated undercapitalization grounds have the opposite, albeit more modest, effect.  The addition of an undercapitalization ground to a veil piercing complaint makes an interstitial veil piercing motion 14% more likely to be successful.  We also find (but do not illustrate) that corporations owned by artificial shareholders are more likely to be subject to successful veil piercing motions than LLCs owned by artificial shareholders.

Here’s what this suggests to me: facade and shell grounds in complaint signal/reflect a case that is pretty thin — the grounds are totally conclusory — such claims fall away in cases at higher-than-usual rates.  By contrast, undercapitalization signals a strong case — one that evidences a certain about of seriousness about the veil piercing claim.   With respect to voluntary creditors (i.e., contract claims) recall that plaintiffs can bring both voluntary and involuntary creditor claims in the same complaint.  Still, the expectation from theory was that voluntary creditors ought to win less often than involuntary ones.  We don’t find that.  We find instead that complaints with voluntary creditor causes of action in them are more likely to be associated with veil piercing claims that survive longer.

The corporation-LLC finding is expected.  LLCs are designed to be more informal.  They ought to be pierced less often.

Case Level Success

As I discussed in an earlier post, figuring out what veil piercing success at the case level means is a little bit complicated. We decided to treat veil piercing at the case level as successful if: (1) the veil has been affirmatively pierced by a court through veil piercing motion activity OR (2) when, after veil piercing has been litigated on the record (through motion activity), the case settles while veil piercing is still “alive” in the case (i.e., having never been dismissed or denied).  In the paper, we provide alternative set of results based on the coding of veil piercing success both more narrowly (excluding all settlements) and more broadly (including all settlements where veil piercing is still “alive,” regardless of the affirmative presence of veil piercing motions in the case).

We again find that employee size has an important relationship to success.  Very small firms have a probability of case level veil piercing of around 20%; that number quickly approaches zero as firm size increase. Similarly, the more conservative a district court judge is, the more likely the case he is presiding over is to have a case-level veil piercing success.  This result, of course, mirrors that in the veil piercing motion context.  While the most liberal judge’s case has around a 15% probability of having ultimate veil piercing success, the most conservative judge’s case has around a 30% probability.

Individual factors also matter.  When companies are incorporated in different states from where they operate (holding their size constant) the presence of such sophistication decreases (by about 10%) the likelihood that the firm’s veil will be pierced.  The inclusion of undercapitalization as a ground increases (by about 10%) the likelihood of there being a successful case-level veil piercing.

The last post in this series will discuss these results.

* * *

FN*  We generally do not find statistical significance at the motions level for our variables regarding entity choice,  shareholder identity, defendant sophistication, judge gender or race, appellate court control, or the increased incidence of success when failure to observe formalities, inadequate capitalization, and domination and control were cited as veil piercing grounds against corporations compared to LLCs

There’s value in this approach, not least because opinions shape reality. But there’s a problem too.  Not only are opinions unrepresentative, but they come late in cases.  The result is an extreme form of selection.  It’s not clear (to me, anyway) what the null hypothesis regarding the effect of independent variables  ought to be for late-stage dispositions.

Dockets offer the promise of a different approach: asking which factors correlate [...]]]> If you look at opinions, winning in a veil piercing case is pretty easy to define: did the court agree to pierce the veil, reaching through an entity to its shareholders. If you were inclined, you could model success at those terminal moments in cases, asking which factors (described in the opinions) correlated with courts agreeing to pierce.

There’s value in this approach, not least because opinions shape reality. But there’s a problem too.  Not only are opinions unrepresentative, but they come late in cases.  The result is an extreme form of selection.  It’s not clear (to me, anyway) what the null hypothesis regarding the effect of independent variables  ought to be for late-stage dispositions.

Dockets offer the promise of a different approach: asking which factors correlate with success or failure early in cases.  Further, assuming that adjudicated motions teach the parties about the strength of their cases, and that they settle strategically, we can even start to learn from the timing and incidence of settlement.

In this post, I’m going to relay some descriptive statistics about the veil piercing successes that plaintiffs achieved in our data. (I’m continuing to pull the data and some text from our paper.)  To those who are getting annoyed by all of these posts, I’m sorry!  I’ve been living with this project for a long time — I’m excited to finally share it publicly.

We coded 550 motions raising veil piercing problems, and 580 non-veil piercing motions, in our 690 cases.  Overall, about half of all veil piercing motions result in plaintiffs advancing their veil piercing claims (but not ending the case), about fifteen percent involve judicial determinations against the veil piercing claim, twenty percent success on the merits (if defaults are included), and the remainder of motions were pending at the time of settlement. (Recall that 2 of 3 cases overall ended in settlement).

Excluding defaults, and dropping pending motions, veil piercing litigation is a story of wild early success: plaintiffs prevailed — in one form or another – on approximately 85% of all veil piercing motions in our dataset.  Many cases had their veil piercing claims still “alive” at the time of settlement.  Indeed, using the most liberal definition, which includes settlement after motion practice as victory, 78% of cases resulted in plaintiffs realizing some value from their veil piercing claims.

But very few cases actually led to veil piercing, on the merits, outside of defaults: only 37 cases, out of 690, contained a judicially-enforced veil piercing on the merits.  That’s around 6%.

Moving parties were less likely to win non-veil piercing discovery motions  than veil piercing discovery (a 67% success rate versus 90% in resolved motions) and plaintiffs were less successful at fighting off motions to dismiss (61% plaintiff prevail rate versus 88%) and summary judgment (62% versus 90%).  One explanation for this effect is that veil piercing motions (i.e., demanding VP discovery, or fighting of a motion to dismiss) are somehow not selected out of cases to the same degree that ordinary motions are: defendants either are too attached to them (think they are going to win when they won’t) or plaintiffs insufficiently so (think they lack settlement leverage when they have it).

The advantage of looking at success and failure at the motion-by-motion level is that it promises a chance to move the problem of selection back in cases to a moment where we wouldn’t reasonably expect for plaintiffs and defendants to have a realistic sense of their chances. We can fairly hypothesize that some independent variables — judicial demographics, plaintiffs and defendant characteristics, legal rules and planning — will affect the parties’ respective successes and failures on (say) the grant rate in motions to dismiss.  As I’ll discuss in penultimate post in this series, that intuition turns out to be basically correct.

Confused?  Read the paper!

Facts like these appear at the heart of longstanding, though little known, allegations against Dick Clark, host of the wildly popular arbiter of successful commercial music decades ago, American Bandstand. Though Clark faced Congressional hearings over such allegations back in the 1960s, they never went anywhere and legal [...]]]> Suppose the host of a show like American Idol insisted that, in exchange for putting participants on air and gaining publicity, participants had to sign agreements transferring copyright and all future royalties from songs they perform on the show to the host. Suppose further that these participants signed such contracts, and ensuing royalty streams generated millions of dollars for the host, nothing to the performer. Would these agreements be enforceable? Under what legal theories could they be challenged?

Facts like these appear at the heart of longstanding, though little known, allegations against Dick Clark, host of the wildly popular arbiter of successful commercial music decades ago, American Bandstand. Though Clark faced Congressional hearings over such allegations back in the 1960s, they never went anywhere and legal claims do not appear to have been pursued. This quiescent state of affairs may reignite amid the new documentary on the subject, Wages of Spin, which suggests that artist and producer reticence to pursue legal claims is due to lack of knowledge or capacity or to how the power Clark wields in the industry has made many potential witnesses and other adversaries reluctant to challenge him.

The film, made by Shawn Swords (who, in the interest of full disclosure, is a friend of mine and high school classmate), is not so much an expose of Clark’s moral compass as an exploration of the tactics he used to run the show. As a documentary, it adopts an objective tone and viewpoint, though undoubtedly does not provide the adversarial forum to explore or test all assertions and counter-assertions that adjudication of disputes provides.

Accordingly limited, the skeletal facts may permit considering, in broad outlines, issues from the common law of contracts concerning the enforceability of such agreements. I mention four below: lack of consideration, unconscionability, illegal bargain and duress. Comments are open to add to this list—or subtract from or qualify it. (Of course, any inquiry like this skirts potentially applicable statutes of limitations, which raise additional issues concerning tolling, discovery, diligence and others that would require considerably more facts to evaluate.)

Consideration.  First, artist-producers could argue that the transfer of their rights lacked consideration. The evidence may show the transfer was not made for sufficient consideration but, at best, for the promise and delivery of time on the air and play time for the records. Under traditional theories of contract formation, however, this claim would be difficult to sustain. Courts routinely say they will not inquire into the adequacy of consideration, so long as some quid pro quo exists. It is probably enough to observe that the deals involved the exchange of royalty assignments for airplay or air time.

Unconscionability.  Second, the artist-producers could allege that, despite the presence of such consideration, the relation between the copyright royalty value and the air time was so lopsided that no reasonable person would have proposed and no rational person would have assented to it. This attempts to invoke the doctrine of unconscionability, a rarely used exception to the usual judicial deference to party determinations of the content of bargains. Although worth considering, this claim may be difficult to sustain given how the value of royalties may well have been dependent upon, and a function of, the airplay or air-time given in exchange.

Illegal Bargain.  Third, the artist-producers could assert that the arrangement amounted to an illegal bargain, one a court should not enforce. This claim could invoke the standard talk of the period that characterized as “payola” the exchange of pay for airtime. It was condemned as an unsavory practice, equivalent to a bribe, though it is not obvious that there were actual laws prohibiting it. Though many courts take the notion of illegal bargain literally, so that refusing enforcement must be based on an exchange that is in substance illegal, some courts invoke a broader sense of public policy in electing to refuse enforcement. Entertaining such a ground to refuse enforcement involves an extensive balancing of the interests in light of related public policy.

Duress.  Fourth, the artist-producers may assert that the agreements were not the product of the exercise of free will but were products of duress that Clark or his associates induced. In general, contracts formed as a result of duress may be set aside, but proving duress requires showing that the opposing side exerted an unlawful threat, improper or coercive influence or techniques to induce assent. This is likewise not a commonly invoked ground for setting aside a contract, and depends heavily on particular facts at the time of contracting. Viewers of the documentary may detect evidentiary leads and predicate assertions to provide a firmer basis for evaluating the probability that this theory to challenge enforceability of the contracts would succeed.

Remedies.  Ultimately, if artist/producers could identify infirmities in the contract formation process, whether lack of consideration, unconscionability, illegal bargain, duress, or otherwise, to what remedy would they be entitled? Since the claim is to set aside the contracts, the remedy is not a contractual remedy but a form of restitution for unjust enrichment. This considers the value of the benefit conferred by the aggrieved party on the benefited party.

In principle, this would mean all royalties under the copyrights would be accounted for and returned—plus reassignment of putative contract rights, including associated copyrights and related royalties. Given the scope of claims implicated—some 143 songs, many of them monster hits—hundreds of millions of dollars would be at stake.

Debate manifested in numerous class action lawsuits, state attorney general investigations under state consumer protection laws, federal legislators circulating bills to curtail the fees, and July 2008 Federal Communications Commission hearings and suggestions for compromise. Much of this energy has dissipated, perhaps partly because some companies have modified some of their contracts, including by adjusting [...]]]> What happened to debate about cell phone subscriber contracts containing early termination fees? Companies and subscribers sign multi-year term contracts, exchanging service for monthly and other fees. Contracts provide that customers terminating early breach and owe damages, usually a flat fee of between $150-225. Companies claim these fees partly compensate them for costs like subsidizing handsets to customers, but customers assert these fees coerce them to continue in an unwanted relationship.

Debate manifested in numerous class action lawsuits, state attorney general investigations under state consumer protection laws, federal legislators circulating bills to curtail the fees, and July 2008 Federal Communications Commission hearings and suggestions for compromise. Much of this energy has dissipated, perhaps partly because some companies have modified some of their contracts, including by adjusting the fee according to when in the term a customer terminates. But not all companies have adjusted and not all contracts have been changed.

Lawsuits continue to wind their way through courts, involving issues ranging from subscriber assertions of unjust enrichment to violation of consumer protection laws. A particularly interesting issue concerns whether the clauses are enforceable under the general common law of contracts. One of the few cases to have resulted in a judicial opinion on the merits grappled extensively with this issue, which turns out to be more complex than one may suppose. Ayyad v. Sprint Spectrum (Cal. Super., Alameda County 2008.)

The court, in a class action, found the clauses unenforceable, though not because they charged subscribers too much, but mainly because the company’s losses from breach by early termination were greater (plus, more generally, the fees did not reflect a compensatory impulse, shown further by how they did not vary with the time of subscriber breach).

This result may be surprising for two reasons. First, as a matter of traditional contract law, concern focuses more on stipulated damages that overcompensate and thus penalize breach rather than those that under-compensate. Second, as a matter of fact, is it likely that company losses from subscriber breach exceed $150-225 per subscriber, on average or on particular contracts?

Legal remedies for breach of contract are designed to compensate aggrieved parties for loss. Within this compensation principle, doctrine shows greater aversion to over-compensation, as by denying losses for emotional distress or punitive damages, rather than under-compensation, reflected in limitations on the compensation principle barring recovery for losses avoidable, unforeseeable or not provable with reasonable certainty.

Law allows parties to express their own remedies by contract, stating sums to be paid by a breaching party to the other upon designated breaches. But law jealously reserves power to police stipulated remedy amounts for reasonableness. Standard tests of enforceability insist that actual damages be difficult to prove with reasonable certainty and that the stipulated sum is reasonable in relation to forecast or actual damages.

Doctrinal talk distinguishes between enforceable clauses by calling them liquidated damages and unenforceable clauses by calling them penalties, nomenclature reflecting contract law’s historically greater aversion to over-compensating than under-compensating aggrieved parties, concentrating the penalty inquiry on how much the breaching party must pay on breach.

But what about stipulated damages clauses that are too small to compensate an aggrieved party’s losses, not a penalty on the breacher but a functional penalty on the aggrieved party? Such cases are less frequent and traditional doctrine, such as the Restatement (Second) of Contracts, does not talk about them.

Its Section 356(1) announces: “A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.” Professor Farnsworth, in his treatise, wrote: “Since it is the in terrorem effect that is objectionable, the proscription applies only if the stipulated sum is on the high, rather than the low, side of conventional damages . . . .”

The few cases calling stipulated damages clauses invalid when too low, rather than too high, often involve other considerations. For example making a real estate buyer’s damages 10% of the purchase price when seller sold the property for a gain 3.5 times that was held invalid. Wilt v. Waterfield (Missouri 1954). Perhaps this was because it was too low, but also because it was invariant to the gravity of the breach, raising doubt about whether it was intended to compensate.

Likewise, though rare, burglar alarm subscribers have recovered actual damages from alarm companies who negligently breach contracts, rather than a much lower stipulated sum. Samson Sales, Inc. v. Honeywell (Ohio 1984). Though traditional contract law can be applied, even calling the low sum a penalty, the negligence feature may warrant departure or relaxation of standard contract law tools.

More recently, and more generally, revised Article II of the UCC is amended to speak not only of damages too high, as before, but also damages too low, something new.

Add to this list the Sprint cell phone case. Though damages were difficult to prove with reasonable certainty, meeting prong one of the traditional test, the sum was not reasonable in relation to forecast or actual damages, lacking suggestion of a compensatory objective.

Aside from being invariant to the gravity of breach (the same flat fee applied without regard to how much time remained on a contract when a subscriber terminated), the main objection was how the sums were too low in relation to the company’s probable forecast or actual losses.

Determining a cell service provider’s actual losses from early subscriber termination is difficult and the estimates of party experts in the litigation differed radically. There is general agreement that the best compensatory measure is the company’s lost profits from subscriber breach.  All also agree that generally means estimating the company’s lost revenue less costs it avoided as a result of the breach.

Lost revenues can be comparatively easier to estimate, based on factors like contract price, minutes charged, usage and so on. The cost side generates intense dispute about classifying costs as fixed or variable, a perennial challenge in calculating contract damages. Fixed costs cannot be avoided after breach, and are included in compensatory damages, but variable costs can be avoided, so are excluded from compensatory damages.

Unsurprisingly, the subscribers’ expert witness offered to show that nearly all costs varied, and got per customer lost profits down to below $10. If believed, the stipulated sums over-compensated, amounted to a penalty, were unenforceable, and breaching subscribers would owe at most about $10 for any breach.

But the company convinced the court that most costs were fixed, not variable, showing lost profits per customer averaged some $525, vastly more than the stipulated damages, ranging from $150-225 per customer. On this basis, the clause was invalid, and customers owed the company damages far greater than the stipulated amount.

Among costs not avoidable as a result of breach, were subsidies companies gave to new customers, like handsets at prices less than cost and free or discounted months of service. As a policy matter, the companies also say this business model, using term contracts, subsidies and termination fees, was essential to the proliferation of cell phones and service to huge numbers of people, in all economic backgrounds, and resulting value of a massive network of users. Benefits radiate throughout the economy, domestically and internationally.

Absent these tools, including the early termination fees, companies say they would have to use a different business model, one that would raise prices, reduce affordability of phones and services, contract the size of the cell phone network, and retard all associated economic gains arising from the current model.

This may also explain why debate seems to have dissipated—though many subscribers still fume at these terms. And the dueling expert arguments about costs avoided are just the first reaching adjudication. They leave a nagging sense that the disparity suggests we are much farther away from the truth than this single judgment suggests.

This seems clearly wrong.  The amendment clause should be interpreted in light of commercial reasonableness, or the contracts are voidable as illusory.  If “may be amended from time to time” means that the Club has the sole discretion to change both signatories’ obligations to the detriment of the members, then we’ve got a pretty clear example of a contract in name only.  Rather, I imagine that the amendment language, reasonably interpreted in light [...]]]> A set of golf club membership contracts provide that they “may be amended from time to time.”  Signatories, who plunked down $185,000 refundable deposits to join once the clubs were operational, want to exercise the refund clause.  The clubs respond that they can exercise their amendment ability and keep the deposits.  Lawsuits result.

This seems clearly wrong.  The amendment clause should be interpreted in light of commercial reasonableness, or the contracts are voidable as illusory.  If “may be amended from time to time” means that the Club has the sole discretion to change both signatories’ obligations to the detriment of the members, then we’ve got a pretty clear example of a contract in name only.  Rather, I imagine that the amendment language, reasonably interpreted in light of commercial norms, is limited to non-material terms -which would not include the refundability of the deposits.  Indeed, the members argue that refundability was a “relatively unusual stipulation [that] was a big part of the appeal of joining.”

What do you think?

(H/T Atrios)

To what damages is the Buyer entitled? According to an intermediate appellate court in New York, which affirmed that Seller breached in bad faith, Buyer is entitled to neither expectancy damages (lost profits) nor reliance damages (as a matter of summary judgment).

Is this likely to be upheld by the New York Court of Appeals, which heard oral argument in the case last week? For the following reasons, I doubt it, but either way [...]]]> Suppose a partnership of two individual real estate developers agrees to buy raw land from a local government authority to develop a retail factory outlet in a special trading zone of upstate New York across the St. Lawrence River from Canada.   A trial court found that the Seller breached this contract “in bad faith.”  

To what damages is the Buyer entitled? According to an intermediate appellate court in New York, which affirmed that Seller breached in bad faith, Buyer is entitled to neither expectancy damages (lost profits) nor reliance damages (as a matter of summary judgment).

Is this likely to be upheld by the New York Court of Appeals, which heard oral argument in the case last week? For the following reasons, I doubt it, but either way look forward to the Court’s opinion.

The lower court denied lost profits by saying they would be too speculative to prove with reasonable certainty. The court acknowledged that Buyer had entered into numerous leases with retailers ready to do business at the factory outlet, but several lessees had since cancelled them. Nor did Buyer show it could have obtained requisite financing to attract and secure tenants for those or other retail spaces (or, perhaps, though the court does not say this, to develop the site).

The court cited a famous New York case, Kenford Co. v County of Erie (1986), announcing that “a start-up commercial enterprise faces a stricter standard when seeking damages for lost profits [because] ‘there does not exist a reasonable basis of experience upon which to estimate lost profits with the requisite degree of reasonable certainty’” (emphasis added).

For at least four reasons, as a matter of the general common law of contracts and of New York law, this statement may be wrong and certainly warrants review. True, courts hesitate to award lost profits damages to “new businesses.” But it is doubtful that there is a blanket rule barring doing so absolutely (as there may have been in a few jurisdictions a long time ago). See MindGames (federal court predicting applicable state supreme court would overrule an antique precedent barring lost profits to any new business).

Second, it may be a mistake to say new businesses face a “stricter standard.” The standard is the same, not only for new businesses and established businesses, but for lost profits and other damages, and for all aggrieved parties seeking contract damages: they all must prove asserted damages with reasonable certainty. 

The problem a new business faces is absence of probative records of past performance that an existing business has to estimate lost profits. It is not a different standard, but a difference in the capacity to generate requisite evidence. It is also possible to sustain the claim on the basis of comparable businesses run by others. See Fera Village Pizza.

Third, New York’s Kenford case, which the court relies on, involved lost profits asserted under a contract to build a domed stadium. The New York Court of Appeals noted longstanding judicial aversion to awarding lost profits in contexts, such as sporting events, that depend on “the whim of the general public and the fickle nature of popular support for professional athletic endeavors.” The landmark case of Chicago Coliseum v. Dempsey famously makes the same point. It may be far easier to prove lost profits under a sales contract for land to be used as a retail factory outlet than for a sports stadium or event.

Fourth, it is not obvious from the opinion why the various procured lessees cancelled their leases, and explanations could include the highly-publicized failure of the government agency to transfer the land in this case. That tenants cancelled tends to support, not undermine, the basis for a lost profits measure.  Further, although the court rejects Buyer’s claim in part because it did not provide evidence that it would have been able to finance the acquisition of additional tenants, it does not elaborate on what financing this would require or how it affected overall development prospects.  These issues of fact make it seem particularly incorrect to grant summary judgment.

In addition to rejecting Buyer’s lost profits claim on potentially weak grounds, the court also denied its alternative claim to reliance damages. Buyer sought to recover costs it incurred in preparing to develop the retail factory outlet center. While the opinion does not detail the elements, one may imagine that they involve costs like advertising and negotiating leases.

The court denied such damages on the ground that nothing in the Buyer-Seller contract(s) said anything about Buyer doing these things. The contracts contemplated the Buyer appearing at the closing, paying for the land and accepting title.  All these costs it incurred at its own expense, the court says.

This decision may also be incorrect for several reasons and certainly warrants review. First, it is common in cases where an aggrieved party is unable to prove lost profits (or other expectancy) with reasonable certainty, to be permitted to recover reliance damages instead. Indeed, that is a feature of the landmark case of Chicago Coliseum v. Dempsey mentioned earlier.

There is a fighting issue about whether reliance damages can be recovered for costs incurred before the contract was made, but that does not seem to be an issue this court addressed or resolved. Additional difficulties arise in determining which outlays were made in reliance on the contract (those that vary with its performance) and which were not.  But, again, the court does not explore these matters.  The court may have been thinking of the restitution cases, where preparations to perform that do not confer benefits on the other party are not recoverable in quantum meruit.  Curtis v. Smith.  But this does not mean they are not recoverable as reliance damages.

In short, the opinion being reviewed resembles a legal fossil of an earlier age. It suggests reviving something of an absolute ban on lost profits for new businesses, long ago abandoned; fails to see the standard modern alternative of reliance damages when lost profits cannot be proven with reasonable certainty; and seems to erect standard limitations on the restitution recovery as (misplaced) limitations on the reliance recovery.

Amid today’s economic recession, many fans, unable to afford the luxury they promised to pay for in flusher times, breached those promises, not paying for tickets. In response, teams have taken self-help measures and sued fans, for breach of contract, seeking damages.

Self-help includes reselling this season’s tickets to other fans, usually at [...]]]> Nationally, and lately here in Washington, DC, sports fans are learning hard lessons in contract law. When franchises, like the Washington Redskins football team, built expensive new stadiums during the economic boom of the mid-2000s, they supported funding with multi-year ticket sales. Partly to get long-term construction loans, teams sold season tickets for up to 10 years, promising designated season tickets in exchange for fan promises to make stated annual payments during the term.

Amid today’s economic recession, many fans, unable to afford the luxury they promised to pay for in flusher times, breached those promises, not paying for tickets. In response, teams have taken self-help measures and sued fans, for breach of contract, seeking damages.

Self-help includes reselling this season’s tickets to other fans, usually at lower prices or, when tickets cannot be sold, using seats for other purposes, like promotional or charitable events. Teams also resold future seasons’ seats, again usually at lower prices, or hold them, hoping for future increases in market price. Measured today, what are a team’s damages?

As a basic matter of contract law, aggrieved parties like these teams are entitled to recover the money equivalent of the promised performance. This protects their expectancy interest by putting them in the position performance would have done. Hawkins v. McGee. Though this compensation principle is easy to state, difficulties appear in working through alternative ways to measure the recovery and limitations on it.

The market price of this season’s tickets is below the contract price for those tickets. If a fan agreed to pay $100 for this season’s seats, now trading (on E-Bay, say) for $75, the measure of the team’s damages would be the $25 contract-market differential. Acme Mills.

For this season’s tickets the team actually resold this year, the measure could be the difference between the contract and resale price (analogous to the market-cover differential awarded to aggrieved buyers in goods transactions). Cf. Missouri Furnace. Supposing re-sale prices ranging from $60 to $80, damages would be $40 to $20 apiece.

For future seasons’ tickets, current fan defaults amount to anticipatory repudiation of future performance. It is not necessary for the teams to wait until future performance dates arrive, years in advance, to sue or recover damages. Hochster v. de la Tour. They are entitled to sue now and recover damages based on the foregoing formulas for tickets to be delivered in the future.

For this season’s or future season tickets, it does not seem possible for teams to claim lost profits on these sales. For some sellers, like retail dealers of standardized goods, it is possible to imagine a capacity to generate additional sales without regard to whether a particular buyer breaches. Neri v. Retail Marine. For such lost volume sellers, the contract-market (or contract-cover) differential may be inadequate to put them in the position performance would have done, entitling them to seek lost profits instead.  See UCC 2-708(2). Given finite limits of stadium seating capacity, it would be difficult for teams to sustain this lost volume/profits argument.

What of limitations on contract law’s compensation principle, particularly concerning avoidable losses? This mitigation doctrine is implicit in law’s recognition of awarding the contract-cover (or resale) differential when aggrieved parties take that step. In effect, the breaching party compensates the aggrieved party by amounts the aggrieved party did not recover using self-help. Yet teams have been unable to resell some tickets, elected not to do so in favor of using them for promotion or charity, or hold them until the economy recovers to get higher prices in the future. Should team damages nevertheless be reduced by the amount obtainable, without unreasonable burden?

In principle, if teams are able to resell tickets but do not, it seems relatively simple under the mitigation principle to charge them with that cost, using the contract-market differential. But if it is not feasible, can customers nevertheless insist on some reduction in damages? A standard way to think about this problem is to award aggrieved parties the contract price, less costs saved as a consequence of the breach. Rockingham County v. Luten Bridge.

Analysis then distinguishes between fixed costs, not saved by a breach, and variable costs, that are saved. To what extent do fan breaches of ticket sales contracts, which may free up seats in the stadium, result in saving the team costs? Teams will say breaching fans save them nothing because costs are fixed, including player salaries, lighting and ventilation, construction loans, publicity and broadcast. Fans may contend that some costs vary with attendance, such as security, concessions and custodial services. Vigorous disputation ensues over this pervasive challenge of classifying costs as fixed or variable.  Langbein; Kearsage.

Further, may teams recover losses beyond standard measures relating the contract price to market or cover prices, with or without mitigation? Teams may claim losses not only pivoting around the ticket price but arising from how empty season-ticket seats may lead to other losses, such as reduced advertising revenue, diminished ticket sales in other parts of the stadium, and deterioration in the team’s brand name and franchise value. Contract law classifies such losses as consequential damages and recoverable under limited circumstances. Several tests are offered to define the scope of recoverable consequential damages, all of which focus on the time of contracting.

The oldest test requires that the aggrieved party communicated its special circumstances that risk extraordinary losses to the breaching party and the latter knew about them. Hadley v. Baxendale. An alternative formulation, the tacit bargaining test, asks whether a party, having considered that prospect when forming the contract, would have agreed to it. Globe Refining (Holmes).  A commonly used contemporary test charges breaching parties with such consequential damages if they had reason to know of them (constructive knowledge). See Restatement (Second) of Contracts, 351. It seems difficult to imagine ticket customers being liable to sports teams for consequential damages under any of these tests.

Even if conceptually feasible for teams to sustain this claim of foreseeability of consequential damages, they would face a further limitation on compensation requiring losses to be proven with reasonable certainty. MindGames.  (This would also impose a constraint on any effort to seek lost profits if, however farfetched, a team argued it was equivalent to a lost volume seller.) To prove consequential damages, teams could marshal evidence showing historical relationships between fan attendance (sold out games, high occupancy in season ticket holder seats) and advertising revenue. It may be more difficult to provide reliable evidence about that link to intangibles such as brand name or franchise value.

A final issue concerns the common practice teams have of circumventing all this by including liquidated damages clauses in season-ticket contracts. These express contract terms often provide that team damages for fan breaches are the full contract price, period. They purport to foreclose alternative measures, such as contract-market or contract-resale (cover) differentials, or even lost profits or consequential damages. They also purport to dispense with limitations on the compensation principle, whether the mitigation doctrine’s avoidable loss limit or the foreseeability limit on consequential damages.

As a doctrinal matter, such clauses are enforceable so long as actual damages are difficult to determine and represent a reasonable forecast of them in any event. Muldoon v. Lynch. The complexity of the foregoing analysis supports concluding that the clauses pass this test.   A Massachusetts court, evaluating these issues in the context of the New England Patriots and its fans, took that position, suggesting the ex ante sense of the Patriots in-house ticket lawyers. Some teams, including the Redskins, are being even more prudent, ex post, withdrawing lawsuits against fans for breach of contract.

Volume 56, Issue 6 (August 2009)

Articles

Overcoming Overdisclosure: Toward Tax Shelter Detection (pdf) Joshua D. Blank

First Amendment Enforcement in Government Institutions and Programs (pdf) Gia B. Lee

Ezra Pound’s Copyright Statute: Perpetual Rights and the Problem of Heirs (pdf) Robert Spoo

Comments

Nonwaiver Agreements After Federal Rule of Evidence 502: A Glance at Quick-Peek and Clawback Agreements (pdf) Jessica Wang

Narrowing the Definition of “Dwelling” Under the Fair Housing Act (pdf) Karen Wong

Addressing Youth Bias Crime (pdf) Jordan Blair Woods

In the Spring, I asked you folks for some help thinking of examples of true Holmesian agreements, “contracts which, when breached, have a similar psychological profile to a speeding ticket.”  It turned out to be pretty hard to identify such agreements, since most people believe breach to be a morally wrongful activity – not simply an option to pay damages at will.  As Jonathan Baron and Tess Wilkinson-Ryan previously have found, the degree to which individuals find breach to be “bad” is quite manipulable:  breaches to gain are worse than breaches to avoid loss, liquidated damages ameliorate feelings of reprehensibility, etc.  Missing from this research has been a psychological theory of what makes breach so aversive.

Tess and [...]]]>

An Advertisement for the Greatest show on Earth"

In the Spring, I asked you folks for some help thinking of examples of true Holmesian agreements, “contracts which, when breached, have a similar psychological profile to a speeding ticket.”  It turned out to be pretty hard to identify such agreements, since most people believe breach to be a morally wrongful activity – not simply an option to pay damages at will.  As Jonathan Baron and Tess Wilkinson-Ryan previously have found, the degree to which individuals find breach to be “bad” is quite manipulable:  breaches to gain are worse than breaches to avoid loss, liquidated damages ameliorate feelings of reprehensibility, etc.  Missing from this research has been a psychological theory of what makes breach so aversive.

Tess and I came up with a working hypothesis: breach is seen as a form of interpersonal exploitation that makes the breachee a sucker.  We’ve put together a paper that reports on a series of experiments supporting this hypothesis, titled (naturally) “Breach Is For Suckers.“  Check out the abstract, after the jump.

This paper presents evidence from three experiments offering evidence that parties see breach of contract as a form of exploitation, making disappointed promisees into “suckers.” In psychology, being a sucker turns on a three-part definition: betrayal, inequity, and intention. We used web-based questionnaires to test the effect of each of the three factors separately. Our results support the hypothesis that when breach of contract cues an exploitation schema, people become angry, offended, and inclined to retaliate even when retaliation is costly. This theory offers a useful advance insofar it explains why victims of breach demand more than similarly situated tort victims and why breaches to engorge gain are perceived to be more immoral than breaches to avoid loss. In general, the sucker theory provides an explanatory framework for recent experimental work showing that individuals view breach as a moral harm. We describe the implications of this theory for doctrinal problems like liquidated damages, willful breach, and promissory estoppel, and we suggest an agenda for further research.

The paper is a further extension of tons of work on reciprocity in the law, as well as Tess’s own work on the “sucker norm.”  I think it adds a unique contribution to the contracts literature in part because it suggests that studying parties’ behavior in one-shot contracts is worth the investment, and thus challenges the views of relational contract theorists, who hold that such discrete contracts aren’t worth the paper they are printed on.

The paper will be out to the law reviews in the next week.  We welcome any reader comments!

Later that day, the seller called the ad a mistake, withdrew it, cancelled associated orders and reversed the credit card charges. It credibly denies any binding agreements were formed.

But is that stance air tight? Basic principles of contract law generally support the seller’s bottom line, though not exactly its reasoning, providing some basis for a buyers’ contract claim.

True, as the seller emphasizes, the advertisement probably was not an offer to enter into a binding contract at all. It did not limit the quantity available nor limit the [...]]]> On Wednesday morning, BestBuy.com, the consumer products seller, advertised 52-inch Samsung HDTVs, usually sold for thousands of dollars, for sale at $9.99. Many buyers ordered at that price, with the seller processing the orders and charging respective credit cards.

Later that day, the seller called the ad a mistake, withdrew it, cancelled associated orders and reversed the credit card charges. It credibly denies any binding agreements were formed.

But is that stance air tight? Basic principles of contract law generally support the seller’s bottom line, though not exactly its reasoning, providing some basis for a buyers’ contract claim.

True, as the seller emphasizes, the advertisement probably was not an offer to enter into a binding contract at all. It did not limit the quantity available nor limit the population of persons to whom it was directed. The ad was merely an ad, an invitation to deal, not manifestation of willingness to be bound to the bargain merely by a member of the public assenting to it by placing an order.

Second, even if the ad were construed, in form, as an offer, the terms of the deal may be in the category of “too good to be true.” A purchase price of much less than 1% of a common, though high-end, consumer product should manifest to reasonable people lack of intention to be bound on those terms.

Third, the ad appeared on a Web site reserving the seller’s right to “revoke offers or correct errors,” even after receiving paid orders. So, again even if the ad were construed as an offer, in form, the Web site reservation allowing revocation of offers or error correction constitute express terms negating any manifestation to make an offer to sell the HDTVs at $9.99.

So there is little basis for saying the ad amounted to an offer those buyers accepted. But that doesn’t end the analysis. It just means the various orders buyers submitted amounted to offers. Then the issue is whether the seller, by processing those orders and related payment, accepted those orders. If so, binding contracts were formed.

This is a more difficult issue than whether the ad was an offer. The buyers are making offers, and the act of taking the order, processing and charging credit cards, would ordinarily constitute requisite manifestation of an intention to be bound.

The Web site reservation concerning the right to revoke offers does not apply because the seller made no offer it can revoke—the buyers made the offers. The Web site reservation concerning error correction may rescue the seller, but it poses an interpretive question.

The two reservations are conjoined, linking right to revoke offers with right to correct errors, which suggests reservation of rights concerning the making of offers. It does not obviously or inevitably speak to errors the company may make when accepting offers customers make.

All this may be far-fetched and somewhat technical, of course, and maybe no one cares about these buyers. After all, what’s the harm? Some excitement about a deal followed by disappointment? But those are interests the law of contract remedies does not protect.

On the other hand, it may matter a great deal. There is some speculation on the Internet that such enticing price quotes are intentionally fashioned to draw attention and shoppers to a site.  It is difficult to verify such assertions and the Federal Trade Commission, charged with policing unfair trade practices such as that, reportedly opines this one was an honest mistake, not a phony or deceptive gimmick.

Even so, the law of contracts can help police such ruses, at least as well as the FTC can.   As a matter of contract law, on these facts, the usual measure of buyer damages would be the difference between the market price of the subject HDTVs (several thousand dollars) and $9.99 (the contract price).  Maybe BestBuy should make an offer of settlement, perhaps granting buyers coupons for discounts on its products.   At minimum, that would maintain customer goodwill put at stake by such errors, and cost much less than plausible aggregate contract damages.

Hat Tip: Justin Davis

Fantastic as it seems, a report proliferating on the Web says a new company in Latvia is using that business model, successfully. Two-month old Kontora Loan Company of Latvia, brainchild of a 34-year old entrepreneur, offers cash loans up to about €700 (about $500) with daily interest rates of 1% (and some opacity on the frequency of compounding). The soul part aside, requirements are modest: borrowers must be Latvian residents and provide name and signature. The company has low overhead, foregoing collection staff or policy, reasoning the soul is security enough. Business is off to a good start, with 200 customers on board, a demographic heavily populated by poor [...]]]> Is a usurious cash loan secured solely by the borrower’s immortal soul enforceable, as a matter of mortal law?

Fantastic as it seems, a report proliferating on the Web says a new company in Latvia is using that business model, successfully. Two-month old Kontora Loan Company of Latvia, brainchild of a 34-year old entrepreneur, offers cash loans up to about €700 (about $500) with daily interest rates of 1% (and some opacity on the frequency of compounding).
The soul part aside, requirements are modest: borrowers must be Latvian residents and provide name and signature. The company has low overhead, foregoing collection staff or policy, reasoning the soul is security enough. Business is off to a good start, with 200 customers on board, a demographic heavily populated by poor drunks recently in bar room brawls.
Regulators in Latvia reportedly do not object, except that its Consumer Rights Protection Center questions the business from “a humanistic standpoint.” It would not take our nascent Consumer Financial Product Safety Commission much effort to find the loans objectionable in the US, although mere excuse from mortal legal obligation may leave risks that human judges cannot exonerate.

As a mere matter of mortal law, there probably is sufficient consideration for the contracts, and duress would not be a defense for the merely impecunious. But drunks could be excused on the grounds of lack of capacity; opacity in the compounding clause may justify excuse for all borrowers based on nondisclosure. In addition, compounding aside, the daily interest rate would be usurious in the US, probably even in Delaware, Nevada and South Dakota, making the whole bargain unenforceable in our courts.  And there is always unconscionability.

But even if excused in the courts of human law, there remains the religious side of the bargain. In Latvia, spiritual leaders vehemently object to the loans and the whole business model. They say the loans are un-Godly and impermissibly prey on people’s fears.

Religious leaders also stress an additional concern, which seems a mixed question of law and religion, and is a bit puzzling: the loan agreements may be assignable. Assuming the contracts are enforceable, they may well also be assignable. Yet does it matter who holds the loan?

As a matter of contract interpretation, one supposes, if the borrower defaults, the soul is lost, no matter who holds the right to repayment. Perhaps the danger is that this firm, reputable enough, may assign the contract to a disreputable one, perhaps one with links to the devil?

Hat Tip: Sara Rothman

Reinvigoration would be necessary because use of the doctrine of waste to upset corporate transactions is nearly as rare as hen’s teeth. Students of contract law, when beginning to study corporate law, find this rarity strange. They are told corporate law is anchored in fiduciary principles that contrast with contract law’s operating assumption of arms’-length transactions warranting extraordinary judicial deference.

True, standard talk in corporate law jurisprudence concerning both fiduciary duty and waste expresses similar interest in [...]]]> Extravagant corporate expenditures are among salacious details revealed during the  economic crisis, from executive compensation, celebratory parties, office renovations and naming sports stadiums. A few courts, even in Delaware, indicate willingness to police extravagance under the hoary corporate law doctrine of waste, and some observers call for reinvigorating that doctrine.

Reinvigoration would be necessary because use of the doctrine of waste to upset corporate transactions is nearly as rare as hen’s teeth. Students of contract law, when beginning to study corporate law, find this rarity strange. They are told corporate law is anchored in fiduciary principles that contrast with contract law’s operating assumption of arms’-length transactions warranting extraordinary judicial deference.

True, standard talk in corporate law jurisprudence concerning both fiduciary duty and waste expresses similar interest in judicial deference, though emphasizing greater willingness to review corporate transactions to evaluate whether officials act in good faith, with due care, and without promoting self-interest over corporate interest. It may be odd, then, that judicial willingness to police corporate transactions under the doctrine of waste is weaker than within traditional law of contracts, such as its doctrine of substantive unconscionability.

Put differently, the issue can be expressed as what kinship exists or should exist between corporate law’s doctrine of waste and contract law, especially substantive unconscionability. The following notes some familiar ways the two show remarkable kinship and the surprising ways they depart from one another. For those looking to corporate law’s doctrine of waste to promote greater corporate accountability, a modest way would simply take more meaningful lessons from the law of contracts.

Corporate law’s doctrine of waste and contract law’s doctrine of substantive unconscionabilty are rarely-invoked tools used sparingly to upset an exchange transaction. Contract law’s sparing use is based on the principle of freedom of contract, along with doubt about judicial competence to evaluate substance of exchanges and deference to individual actors. Corporate law’s sparing use is based on the principle of business judgment, along with like doubt and deference.

Talk in both doctrines overlaps. First, both bodies of law are averse to gifts, although for different reasons. Contract law’s basic principle of consideration marks off as unenforceable promises to make gifts lacking the indicia of bargain seen as central to enforceable exchange transactions; corporate law’s doctrine of waste prohibits gifts of corporate assets when absence of bargain means the corporation received nothing in exchange.

Second, both bodies of law do not insist on any particular or manifest equivalence of the terms of bargain, enforcing and not upsetting transactions so long as the consideration is minimally adequate. In traditional contract law, this is the peppercorn theory of consideration, and works to the extent that even nominal consideration can perform functions required to separate exchanges from gifts. In both contract and corporate law, the issue is whether there is any consideration and, in corporate law, at least some relation between what the corporation transferred and what it received.

Third, both bodies of law investigate adequacy of consideration issue by posing similar questions using similar syntax. In contracts, an exchange or term may be stricken as substantively unconscionable only if no fair minded person would propose it and no rational person would assent to it. In corporations, a transaction may be upset only if the consideration is so inadequate in value that no person of ordinary sound business judgment would deem it worth what the corporation paid.

Despite affinities, numerous differences appear in these contract and corporate law doctrines. Contract law is quintessentially premised on freedom of exchange and assumes party competency and capacity, so that people lacking the latter traits can elect to be excused from contractual obligation. Corporate law is primarily fiduciary law, premised on the idea that officers and directors act on behalf of the corporation and must advance its and shareholder interests, not personal interests. To that extent, one may expect the otherwise roughly equivalent policing doctrines to be more frequently or robustly used in corporate law than in contract law.

But surveys of casebooks and other resources suggest that may not be the case. Indeed, contract law tends to resort to unconscionabilty doctrine only when no other available grounds exist to provide traditional doctrinal excuse, such as lack of capacity or competency, non-disclosure, misrepresentation, breach of warranty, duress, fraud or mistake. In corporate law, a claim of waste is so difficult to sustain that it rarely is possible to prevail unless there is some other grounds for challenging a transaction, such as breach of the duty of care or loyalty or fraud or ultra vires (corporate law’s functional equivalent to lack of capacity or competency, even more rarely used than waste in modern times).

Finally, contract law’s propensity to use substantive unconscionability to police exchanges intensifies according to a fairly coherent logic. First, it is least likely to be used in true arms’-length transactions, even on lopsided terms, like a grubstake contract that pays off 200:1, even by one of uncertain mental capacity, or an emergency loan contract that pays off 80:1, even in a time of war and famine.

Second, it is more likely that a court in equity, at least, would refuse specific performance of a land sale contract with a value ratio of say 40:1, even if not saying it would refuse to award money damages for its breach.

Third, contract law’s policing becomes most likely when a contract is between those in a confidential or fiduciary relationship, such as brother-sister and business manager-client, as when invoking notions of constructive fraud to refuse enforcement of a land sale contract with a value ratio of as little as 15:1. Similarly, it is most likely when a contract is formed at the urging of a trusted relation, such as a an intimate partner, as to exchange a contractual annuity right for a 1/4 of its face value.  It is also invoked to refuse enforcement of a prenuptial contract on massively lopsided terms.

So contract law’s logic is to become increasingly skeptical of lopsided exchanges as one moves from arms’-length transactions, to those evaluated in equity, and those involving special relationships of confidence, trust and fiduciaries. It is odd, then, that corporate law, fundamentally a fiduciary body of law founded in equity, remains strongly deferential to lopsided exchanges.

Among the few examples of successful invocation of the doctrine of corporate waste are the award to directors of stock options with an exercise period lasting a decade after they leave office or when a corporation allows an executive to discharge a loan in full by repaying only half of it.  At the other end, massive salaries are outside the doctrine, because they so easily meet a longstanding test, stated by the Supreme Court in 1933 (before Erie), denying waste unless there is “no relation” between what the corporation gives and gets.  That is a reason why a Delaware company defeated a claim of waste a few years ago even when it paid a newly recruited executive $140 million for a year’s work that was totally unsatisfactory.

So it is exceedingly difficult for shareholders to win claims of corporate waste. Certainly, it is nearly impossible to sustain such claims to challenge mergers or dividend policy.  Even as to compensation claims, the context of its likeliest utility, success is rare, when adequate consideration can even be found solely from the possibility that an executive may in the future be available to provide consulting services to the corporation.

Contract law’s policing devices for unconscionable bargains is rarely used too, of course, especially concerning substantive terms of exchange. It is more frequently invoked concerning terms of employee or consumer contracts containing obnoxious clauses concerning matters like arbitration or termination. To that point, one difference between contexts these laws address is the lesser perceived need for judicial superintendence and protection of shareholders of corporations compared to consumers, employees and other vulnerable types signing contracts of adhesion containing dense boilerplate overwhelmingly one-sided.

Yet when a large number of American households have increasingly come to rely upon stock ownership as the primary savings vehicle for retirement, especially through employer defined-contribution plans, the difference between consumers, employees and shareholders diminishes. It may be defensible and desirable for courts, even in Delaware, to sharpen, even if slightly, their oversight of corporate decision making under the doctrine of corporate waste.  The basic law of contracts can help.  

At least, I think, there may be an article to write investigating the doctrine and its current and potential kinship with contract law and its doctrine of substantive unconscionability.  Thanks to my RA, Christa Laser, we are researching this possibility this summer.  Thoughts are eagerly welcome on its viability.

Hat Tip: Christa Laser

NBC’s Ann Curry asked whether there was enough time for [Mason's client] to commit [a crime]. An unidentified person said, “The defense says no.”

“I challenge anybody to show me,” Mason said. “I’ll pay them a million dollars if they can do it.”

Kolodziej did it, though some quick driving, and he now wants his million dollar reward, under a theory of a breach of a unilateral contract.

The case isn’t frivolous per se, but it is unlikely that Kolodziej will make it past summary judgment.  This seems like a textbook example of [...]]]> Contract professors are excited by this lawsuit out of Texas, in which law student Dustin Kolodziej sued Orlando attorney Cheney Mason for failing to pay up on a boast he made while being interviewed on Dateline.

NBC’s Ann Curry asked whether there was enough time for [Mason's client] to commit [a crime]. An unidentified person said, “The defense says no.”

“I challenge anybody to show me,” Mason said. “I’ll pay them a million dollars if they can do it.”

Kolodziej did it, though some quick driving, and he now wants his million dollar reward, under a theory of a breach of a unilateral contract.

The case isn’t frivolous per se, but it is unlikely that Kolodziej will make it past summary judgment.  This seems like a textbook example of a boastful puff which no reasonable person in Kolodziej’s shoes would believe constituted an offer.  As in the new casebook classic Leonard v. Pepsico, Inc., 88 F. Supp.2d 116 (S.D.N.Y. 1999), a judge will likely note that the setting (directed at the world, not to a particular person), the offeror’s role (hyperbolic advocacy), the nature of the communication (a  “challenge”), and the amount involved (disproportionate to any gain to the offeror) all combine together to destroy the requisite seriousness & formality that distinguish offers from puffs.

Throwing the case out is the right result.  Ordinarily courts rely puffery doctrine too often – harming  consumers who have relied to their detriment on sellers’ optimism.  But here, as in Pepsico, Kolodziej seeks to force a contract on Mason, or at least a settlement.  Gotchya contracts like this don’t fit well in any theory justifying enforcement.  As an extra weight on the scale here, contractual enforcement would chill a defense lawyer’s efforts on behalf of his client.

This isn’t to say that all publicized rewards are unenforceable.  Kodak has just offered $5,000 to some poor kid who failed to meet Megan Fox.  Unlike Kolodziej’s case, there is only one potential offeree, the offer is accompanied by a way to communicate acceptance, the amount is reasonable, and Kodak’s goal (to document how a “photograph can connect and change the lives of two complete strangers”) is commercial and understandable.

In the event that you do disagree with me, either about the specifics of the post or about puffery more generally, you are on notice that the title of this post is a joke.

Bob’s opening post about the ALI Principles of Software Contracts project alludes to commentators who criticized Section 3.05(b)’s purported immutability.   As a commentator to Bob’s post noted, a joint letter between rivals Linux and Microsoft is the most prominent example of this critique.  According to lawyers representing the software concerns, a “far better way” of addressing the implied warranty of no material hidden defects would be to make it disclaimable, since implied warranties are ordinarily disclaimable under the UCC.

As Bob’s post points out,  3.05 isn’t strictly speaking immutable at all: the vendor can “contract out” by simply disclosing the defect!  And even were that not true, contracts transferring goods with defects that are (i) material; (ii) known to the seller [...]]]>

The ALI Delegates at Work

Bob’s opening post about the ALI Principles of Software Contracts project alludes to commentators who criticized Section 3.05(b)’s purported immutability.   As a commentator to Bob’s post noted, a joint letter between rivals Linux and Microsoft is the most prominent example of this critique.  According to lawyers representing the software concerns, a “far better way” of addressing the implied warranty of no material hidden defects would be to make it disclaimable, since implied warranties are ordinarily disclaimable under the UCC.

As Bob’s post points out,  3.05 isn’t strictly speaking immutable at all: the vendor can “contract out” by simply disclosing the defect!  And even were that not true, contracts transferring goods with defects that are (i) material; (ii) known to the seller at the time of sale; and (iii) hidden would create a serious problem of good faith, which is not generally disclaimable under the common law or under the UCC.   Providing a good that the seller knows is materially defective — when the buyer can not learn that fact before the purchase is completed – would very likely be bad faith.  But why not permit such bad faith conduct to be disclaimed?  Can’t Microsoft simply come out and say

“There is an implied warrant out there that promises you that the copy of Windows you are about to buy isn’t materially defective.  Without admitting, or denying, that this particular copy of windows contains a material, hidden, defect, we hereby disclaim that warranty.  Go pound sand.”

On a particular variant of economic theory, permitting sellers to disclaim the warrant of no material hidden defects would provide useful information to buyers about goods, enabling a market about such warranties to develop.  If buyers wanted to buy software without material hidden defects, they would demand such terms from sellers, paying a premium over buyers who are content to live with the possibility of the software crashing their computer through a defect known to sellers.  On the other side of the sale, sellers might seek to develop & sell reputations as companies that don’t wish to behave in bad faith toward purchasers.  By standing by implied warranties, such companies would be able to differentiate themselves from others.  Thus, Microsoft might continue to deploy buggy software at a cheap price, while Apple would burnish its status as a luxury seller.

A serious problem with this story is that groups of consumers don’t react to warranty terms for software in a way that creates the possibility of a virtuous cycle.  (Bob’s the expert on that topic, and I hope he’ll engage with it in a later post.)  But another problem is definitional.  We don’t permit contracting entities to contract out of good faith because good faith is a necessary condition for contractual enforcement.  It’s part of what makes a contract worth enforcing.  Thus, both willful breach (the topic of some great recent work) and willful bad faith both take promissors and promisees outside of the ordinary contractual framework, where everything is subject to private agreement, and encourage judges to instead impose public, redistributive, values.

But why would that be?  My pet theory turns on the extraordinary remedy for breach of contract:  expectation damages available even for wholly executory agreements.  Expectation protects a very odd social interest – reliance on another’s promise – by dispensing with its proof.  Think about it.  You can recover your expected profit for a breach of a contract that you’ve just agreed to, though you haven’t invested one cent in reliance on the bargain.  The expectation interest thus gives parties entering contracts with a tremendous subsidy.  But like most government subsidies, there is a string attached. Here, the price of expectation is a moderate degree of unselfishness, and thus an immutable good faith doctrine.

On May 19, the membership of the American Law Institute unanimously approved the final draft of the Principles of the Law of Software Contracts. As the Introduction to the project states, the Principles “seek to clarify and unify the law of software transactions.” The Principles address [...]]]> Thanks to Dave Hoffman, who just completed a very successful visit at Cornell Law School, for inviting me to be a guest blogger for the month. Maureen O’Rourke, the Associate Reporter on the Principles of the Law of Software Contracts, and I are posting the following to acquaint readers with the Principles and also to respond to some criticism of one section of the Principles that creates, under certain circumstances, an implied warranty of no known material hidden defects in the software.

On May 19, the membership of the American Law Institute unanimously approved the final draft of the Principles of the Law of Software Contracts. As the Introduction to the project states, the Principles “seek to clarify and unify the law of software transactions.” The Principles address issues including contract formation, the relationship between federal intellectual property law and private contracts governed by state law, the enforcement of contract terms governing quality and remedies, the meaning of breach, indemnification against infringement, automated disablement, and contract interpretation.

The Introduction to the Principles explains further that “[b]ecause of its burgeoning importance, perhaps no other commercial subject matter is in greater need of harmonization and clarification. . . . [T]he law governing the transfer of hard goods is inadequate to govern software transactions because, unlike hard goods, software is characterized by novel speed, copying, and storage capabilities, and new inspection, monitoring, and quality challenges.” Many of the rules of Article 2 of the UCC therefore apply poorly to software transactions or not at all, and the Principles are intended to fill the void.

The Principles are not “law,” of course, unless a court adopts a provision. Courts can also apply the Principles as a “gloss” on the common law, UCC Article 2, or other statutes. Nor do the Principles attempt to set forth the law for all aspects of a transaction, but instead rely on sources external to the Principles in many areas.

The Principles apply to agreements for the transfer of software or access to software for a consideration, i.e., software contracts. These include licenses, sales, leases, and access agreements. The project does not apply to the exchange of digital media or digital databases. It applies a predominant purpose test to determine applicability to transactions involving embedded software or software combined in one transfer with digital media, digital databases, and/or services.

We are the Reporter and Associate Reporter of the software principles. We have been greatly aided by our advisors, consultative group members, ALI Council members, liaisons from the National Commissioners on Uniform State Law, Business Software Alliance, and the American Bar Association, and many additional lawyers from industry and other groups who, over the last five and one-half years, have met with us, talked with us on the phone, and exchanged e-mails with us. We believe the project moved along smoothly largely because of the efforts of all of these groups and individuals.

Nevertheless, in the two weeks leading up to approval in May, we received communications from a few software providers evidencing concern largely with one section of the Principles. Section 3.05(b) creates a non-excludable implied warranty that the software “contains no material hidden defects of which the transferor was aware at the time of the transfer.” The section only applies if the transferor receives “money or a right to payment of a monetary obligation in exchange for the software.” Because the section may be the most controversial provision, we devote the rest of this post to the issue.

Despite concerns that section 3.05(b) creates “new law,” it simply memorializes contract law’s disclosure duties and tort’s fraudulent concealment law. The section makes clear that these rules apply to software transfers in order to allocate the risk to the party best able to accommodate or avoid the costs of materially defective software. Obviously this is the transferor in situations where only it knows of the material defect and the transferee cannot protect itself. The section requires that the transferor knows of the defect at the time of the transfer (negligence in not knowing is not enough to trigger liability), the defect is material, and it is hidden.

A few software providers have concerns that the concepts of “hidden,” and “material defect” are obtuse and will “increase litigation” or require a flood of “detailed notices” to prospective users. These concepts, however, are hardly unknown to the law. A comment to section 3.05(b) says that a “hidden” defect occurs if the “defect would not surface upon any testing that was or should have been performed by the transferee.” This is nothing new. See, e.g., UCC 2-316(3)(b) (”there is no implied warranty with regard to defects which an examination ought in the circumstances to have revealed to [the buyer]“).

A few software providers also worry about the meaning of “material defect.” The comments to section 3.05(b) point out that the section simply captures the principle of material breach: Does the defect mean that the transferee will not get substantially what it bargained for and reasonably expected under the contract? The criticism that “materiality” is too vague, if accurate, would mean that contract law would have to abolish its material breach doctrine too.

Putting together the requirements of actual knowledge of the defect at the time of the transfer, that the transferee reasonably does not know of the defect, and that the defect constitutes a material breach means that a transferor would be insulated from liability in situations identified by the concerned software providers as problematic. These include where the transferor has received reports of problems but reasonably has not had time to investigate them, where the transferee’s problems are caused by uses of which the transferor is unaware, where the transferor learns of problems only after the transfer, and where the problems are benign or require reasonable workarounds to achieve functionality. The best example of when section 3.05(b) would apply is, as comment b to the section says, where the transferor already knows at the time of the transfer that the software will require “major workarounds . . . and cause[] long periods of downtime or never [will] achieve[] promised functionality,” the transferee cannot discover this for itself, and the transferor chooses not to disclose the defect.

As we have already said, the section simply memorializes existing law. Under the common law, a contracting party must disclose material facts if they are under the party’s control and the other party cannot reasonably be expected to learn of the facts. Failure to disclose in such circumstances may amount to a representation that the facts do not exist and may be fraudulent. See, e.g., Shapiro v. Sutherland, 76 Cal. Rptr. 2d 101, 107 (Cal. Ct. App. 1998) (”Generally, where one party to a transaction has sole knowledge or access to material facts and knows that such facts are not known or reasonably discoverable by the other party, then a duty to disclose exists.”); Hill v. Jones, 725 P.2d 1115, 1118-19 (Ariz. Ct. App. 1986) (”[U]nder certain circumstances there may be a ‘duty to speak.’ . .  . N]ondisclosure of a fact known to one party may be equivalent to the assertion that the fact does not exist. . . . Thus, nondisclosure may be equated with and given the same legal effect as fraud and misrepresentation.”). The Restatement (Second) of Contracts section 161(b) states that “[a] person’s non-disclosure of a fact known to him is equivalent to an assertion that the fact does not exist . . . where he knows that disclosure of the fact would correct a mistake of the other party as to a basic assumption on which that party is making the contract and if non-disclosure of the fact amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.” Section 161, comment d of the Restatement (Second) adds “In many situations, if one party knows that the other is mistaken as to a basic assumption, he is expected to disclose the fact that would correct the mistake. A seller of real or personal property is, for example, ordinarily expected to disclose a known latent defect of quality or title that is of such character as would probably prevent the buyer from buying at the contract price.”

One concern of a commentator is that fraudulent concealment is a tort, implying that it has no place in the Principles. But the principle appears prominently in the Restatement (Second) of Contracts section 161. And why not memorialize a principle that discourages a party in a contract setting from hiding material facts that the other party reasonably does not know? The commentator notes that fraudulent concealment requires intent to deceive, but wouldn’t that be the usual inference if a transferor licenses software it knows is materially defective and knows the transferee cannot discover it?

A few organizations also are concerned that section 3.05(b) cannot be disclaimed. But there are plenty of cases that do not allow a party to contract away liability for concealment. One critic wonders why a statement such as “I am not giving any assurances about there being no defects in this software,” should not insulate a transferor from liability. A reasonable licensee, assuming the good faith of the licensor, would believe that this licensor does not intend to make any express warranties or implied warranties of merchantability or fitness, not that the licensor knows that the software is materially defective so that the software will be largely worthless to the licensee. A transferor playing this game is surely in bad faith and, frankly, engaging in reprehensible conduct. But there is a way to ensure no liability under this section, namely to disclose material hidden defects. In effect, disclosure is the disclaimer.

Bob Hillman and Maureen O’Rourke
June 2, 2009