"I realise that some of my criticisms may be mistaken; but to refuse to criticize judgements for fear of being mistaken is to abandon criticism altogether... If any of my criticisms are found to be correct, the cause is served; and if any are found to be incorrect the very process of finding out my mistakes must lead to the discovery of the right reasons, or better reasons than I have been able to give, and the cause is served just as well."

-Mr. HM Seervai, Preface to the 1st ed., Constitutional Law of India.

Thursday, April 12, 2018

Efficient Breach as a Justification for Specific Performance as an Exception

Readers may recollect the two recent posts in this blog (here and here) on the proposed amendments to the Specific Relief Act, 1963. Taking the topic forward, we discuss why damages and not specific performance is the default remedy. We discuss the efficient breach theory as popularised by Richard Posner and others. 

The Efficient Breach Theory

Efficicent breach theory was first introduced by Robert Birmingham in a 1970 article Breach of Contract, Damage Measures and Economic Efficiency, 24 Rutgers L Rev 273 (1970) and was subsequently developed by Richard Posner’s 1972 book titled, Economic Analysis of Law.

One of the most powerful theoretical justifications to the principle that damages should be the default remedy in case of contractual breaches and specific performance should be the exception is the efficient breach theory. As early as in 1897, OW Holmes famously stated: "The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it- nothing else." This is the battle cry of the proponents of the efficient breach theory.

The theory of efficient breach argues that damages as awarded by courts gives the promisor an incentive to perform the contract except when the result would be an inefficient use of resources. In such a case, the theory prescribes, promisor should be allowed to breach the contract so long as the victim is adequately compensated. The theory seems to be morally repugnant on the face of it but its appeal can be explained through a hypothetical example. 

What does the Theory Say? A hypothetical Case

Let us take a hypothetical case of laptop and processors business. The hypothetical case is slightly complicated and hence readers may pay close attention to each word in the case.

On 01.01.2018, manufacturers of processors, Dintel enters into contract to sell processors to Denovo Computers, a manufacturer of laptops. As per the contract, Dintel is supposed to deliver 100 units to Denovo on or before 01.07.2018. If Dintel breaches the contract, Denovo can procure the equivalent processors from another manufacturer, CMD at, say, around the same rate and without much delay. But Dintel's maximum capacity is only, say, 100 units in seven months.

Under the contract, Denovo is to pay Rs. 10000 per Processor or Rs. 10,00,000 by 01.08.2018 for delivery thereof. Dintel has to spend Rs. 8000 on manufacture, shipment and overheads. Denovo has to use the processors to manufacture laptops. On top of the cost it would incur for the processor, Denovo has to spend an extra Rs. 6000 per laptop (for other parts) and will sell the laptop at Rs. 18,000.
  • Total cost of producing the laptop = Rs. 8000 (cost of processor) + Rs. 6000 (other parts of the laptop) = Rs. 14,000.
  • Overall value created out of the deal= Rs. 18,000 (selling price) – Rs. 14,000 (cost) = Rs. 4000
  • Of the value of Rs. 4000, Rs. 2000 will go to Dintel (Rs. 10,000- 8000) and Rs. 2000 will go to Denovo [Rs. 18,000- (Rs. 10,000+6,000)]

Depending upon the relative bargaining power, either Dintel or Denovo may adjust the profit but would generally not make a loss-making deal, such as selling the processor at Rs. 6000 to Denovo (loss to Dintel) or at Rs. 13000 (loss to Denovo)

Although the above deal presents overall value to both parties, risks involved or new situations could make the deal unattractive to either one of them. One such situation is discussed below:

Consider a scenario where on 01.04.2018, YECHEE, a competitor to Denovo offers Rs. 13,000 per unit of 100 processors for delivery on 01.07.2018. YECHEE is offering so because it can produce the remaining parts in cheaper costs using its technology at just Rs. 3000. Please recollect that the overall value created in the transaction between Dintel and Denovo was Rs. 4000, that is, Rs. 18,000 (selling price) – Rs. 14,000 (production cost) = Rs. 4000. 

Whereas the overall value created in the transaction between Dintel and YECHEE would be [Rs. 18,000 (selling price) – (Rs. 8000 + Rs. 3000)] = Rs.  7000. [note that the production costs for YECHEE apart from the processor cost is just Rs. 3000.

Therefore, maximum social welfare (selling value minus production costs) would be achieved if the transaction between Dintel and YECHEE is allowed. In other words, if Dintel is allowed to breach the contract with Denovo, subject of course on payment of damages, both Dintel and Denovo will be well-off. This is, in simple, what the efficient breach theory prescribes: it would be socially optimal for Dintel to breach the contract and allow Dintel to enter into a deal with YECHEE provided Denovo is compensated. It will be a win-win situation for the victim of breach, for the promisor, and for the third party, YECHEE. Hence ,there will be no point in awarding specific performance, as specific performance will lead to a lesser overall societal value and will result in two disappointed parties (Dintel and YECHEE) of the three. This is the basis for the rule that specific performance will not be awarded where damages would adequately compensate the victim of breach. 

A Case for Specific Performance in the Above Scenario: Readers may recollect the assumption above that If Dintel breaches the contract, Denovo can procure the equivalent processors from another manufacturer, CMD at, say, around the same rate and without much delay. What if this assumption is not there? What if, owing to Dintel's breach, Denovo will not be able to supply laptops to its long-term customers, and which will lead to loss of reputation and a huge loss in market share such that the said losses would mean Denovo losing crores of rupees. Would breach still be allowed? In this situation, the breach would make Denovo seriously worse off, and would be a situation where damages would not adequately compensate Denovo. Therefore, specific performance would have to be ordered.

This is, in simple, the efficient breach theory.

Criticisms of the Efficient Breach Theory

So much was the theory’s influence that in 1983 Restatement (Second) of Contracts, the theory received a tentative endorsement” in the Introductory Note on Remedies with a caveat, which represents two broad strands of criticism- morally repugnant and reliance on false assumptions. In view of the criticisms, it appears that the theory was further refined but certain criticisms continued to be unsatisfactorily answered by the theory. 

Moral Repugnancy: This strand of criticism stems for the contract as a promise theory. 
  • The efficient breach theory encourages parties to a conduct (breaching the contract) which laws should condemn.
  • The theory allocates all gains from the wrong (breach) to the wrong-doer while affords no-loss-no-gain to the original buyer.
  • Critiques ask what will happen to the market and the sanctity of bargains if the chain goes on?
False Assumptions: Critiques argue that the theory is based upon several false assumptions.
  • It largely ignores transaction costs. It offers no account of how the breaching parties come to pay expectation damages- litigation will consumer lot of judicial and party resources which may even lead to huge costs making the transaction socially inefficient.
  • What happens especially in a situation like in India where it takes several years to award damages and to recover it, especially where the promisor refuses to pay damages?
  • The theory assumes perfect information. In actual world, damages measure and the calculations on profit/ overall welfare are complicated and unpredictable. Further, many meritorious cases fail due to lack of evidence or negligence of counsel/ parties.
  • The theory wholly ignores market reputation and repeat play, especially in long-term scenarios. Parties may not be cold-blooded and self-interested in such cases.
Despite the serious criticisms that the theory faces, the theory presents a power justification for the rule that specific performance should be the exception and damages should be the default remedy.

More on this topic in another post. 

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