Reliance Interest in Contract Damages and Expectation Damages

In the past few weeks, we have been discussing the recently proposed amendments to the Specific Relief Act, 1963 (this, this and this). In this post we discuss one of the most monumental contributions to contract law, Fuller & Perdue's paper, "The Reliance Interest in Contract Damages", which was published in two parts (Part 1 & Part 2). One of the main ideas in the paper was the popular (or notorious, depending on your view) three-fold classification of contract damages. We also discuss the reason why expectation damages are awarded in contract law.

The Three-Fold Classification of Damages

F&P classified the reasons for the award of damages into protection of three kinds of interests:

• Restitution interests: The restitution interest consists of any benefit the promisee has provided the breaching party. For example, if a seller agrees to make monthly deliveries of a commodity in return for fixed payments due 60 days after each delivery and the buyer repudiates the contract after receiving and retaining two deliveries but making no payments, restitutionary damages would restore to the seller the value of the delivered goods.
• Reliance interests: The reliance interest is measured by the promisee’s wealth in the pre-contractual position. Reliance damages provide compensation both for any benefit conferred on the breaching party and for any other reliance investments made by the promisee in anticipation of performance to the extent such investments cannot be recovered.
• Expectation interests: The expectation interest is measured by the net benefit the promisee would receive should performance occur.

After making the three-fold classification, F&P observed:

• In most instances, the restitution measure will provide the lowest amount of recovery and the expectation measure the highest recovery. 
• However, the restitution measure will provide the strongest claim while the expectation measure will provide the weakest. The restitution measure seeks to correct unjust impoverishment of the breacher and the unjust enrichment of the non-breacher. In case of reliance interest, it seeks to correct the unjust loss suffered by the non-breacher but does not undo any corresponding gain of the breacher. 

The three-fold classification has attained a lot of prominence. Two papers could be referred to for a critique of the classification: Friedmann, The Performance Interest in Contract Damages (1995) 111 LQR 628 and Richard Craswell, Against Fuller & Perdue, 67 Uni Chi L Rev (2000). The two articles criticise F&P on numerous grounds. We do not need to go into these criticisms for the purpose of the present article but the classification presents a simple and a powerful analysis of the interests sought to be protected by contract law. F&P's contribution is regarded as influential so much that it has been regarded as the most famous contract article ever written (see Friedmann). Like many influential works, it appears that F&P's article went unnoticed for a long time. Later, it was dusted off from the graveyard of law review articles, taught, analysed and criticised.

The interesting trivia around the F&P article is that Perdue was a third year research assistant of Lon Fuller. The theoretical parts of the paper were written by Fuller himself and the case laws were researched by William Perdue Jr. Another interesting trivia is that Richard M Nixon, the former American president (the only President of the US to have resigned- notorious for the Watergate scandal) would have "almost served as Fuller's research assistant" for the article (see, William M. Wiecek, The History of the Supreme Court of the United States, p. 449, foot note 39). Fuller should be credited for the ethical decision to let Perdue be the co-author for the work. This is an important lesson for academicians in India. In an age where research supervisors hijack the work of research scholars and at times sexually abuse them, Fuller's action of acknowledging Perdue as the co-author should be the lesson that academicians should learn.

Why Expectation Damages?

The concept of "expectation damages" was further brought to the mainstream by the law and economics scholars, who argued that so long as performance is not inefficient (notice the double negative), expectation damages provide the incentive for the promisor to perform the contract. If there is no expectation damages, the promisee would be left with non-performance, which was not desirable from the social welfare point of view.

[Note: The next part of this post cannot be understood unless the previous post is read]

Now read the hypothetical case discussed in the previous post (read carefully). The profit of Dintel in the transaction between Dintel and Denovo was Rs. 2,000 (Rs. 10,000- Rs. 8,000). The benefits out of the transaction for Denovo was Rs. 2,000.  But the profit of Dintel in the transaction between Dintel and Yechee was Rs. 5,000 (Rs. 13,000- Rs. 8,000). If Dintel was allowed to breach after compensating Denovo for Rs. 2,000, Dintel would still earn Rs. 3,000 (Rs. 5000-Rs 2000), which was provided as the justification for the efficient breach theory. It was a win-win situation for all the three parties (under the assumption that Denovo could make alternative arrangements). 

Now what would have happened if Yechee offered only Rs.11,000? After compensating Denovo (of Rs. 2000), Dintel would have earned a profit of only Rs. 1000, which was Rs. 1000 less than what it would've earned had it performed the contract with Denovo. Consider a scenario where Yechee offers only Rs. 11000 to Dintel, and if Dintel breaches the contract with Denovo, Denovo would have to pay Rs. 2000 for alternative procurement for another company CMD. In a case where expectation damages does not exist (and Dintel did not incur costs), Dintel would simply breach the contract with Denovo, leaving Denovo in the lurch, and go for Yechee's contract, thus earning a cool profit of Rs. 3,000. Denovo would then have to spend Rs. 2,000 extra and its profits from the sale of the laptop would be eroded, leaving Denovo worse off. Only if expectation damages existed would Dintel be prevented from breaching the contract with Denovo as it would earn a profit only of Rs. 1000 giving no incentive for Dintel to breach the contract with Denovo. 

This is the justification for expectation damages. More on the relevance of this discussion in the next post.