Sample - B - Impossibility Doctrine in Contract Law

Sample - B - Impossibility Doctrine in Contract Law - ECON...

Info icon This preview shows pages 1–20. Sign up to view the full content.

View Full Document Right Arrow Icon
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 2
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 4
Image of page 5

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 6
Image of page 7

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 8
Image of page 9

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 10
Image of page 11

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 12
Image of page 13

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 14
Image of page 15

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 16
Image of page 17

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 18
Image of page 19

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 20
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: ECON 404 ECONOMICS. AND THE LAW An Ecanamic Analysis of the Impassibiiity Baetrim in Can-tract Lem An Economic. Analysis of the Impossibility Doctrine in. Contract Law It is a fact universally acknowledged that persons who wish goods and services to be in their most valuable uses must be in want of voluntary exchange. However, there is no guarantee that the agreedwupon exchange will take place instantaneously. In most cases, the performance of this voluntary exchange takes place in the future — a fact that inevitably introduces uncertainty. Uncertainty and risks are two sides of a coin. Therefore, contracts are used as an efficient way of allocating these risks between the parties to the voluntary exchange. Yet, in the real world contracts are no more perfect than humans are. As a result, a system of contract law is needed to facilitate voluntary exchange. The purpose of contract law is two—fold: (I) it protects parties who perform in good faith from those who do not, and thereby reducing the uncertainty of exchange transactions and the costs associated with that uncertainty; (2) it provides a remedy to the imperfections inherent in every contract by supplying contract terms or contingency clauses that both parties would probably have agreed had they sat down and negotiated over them, and thereby reducing the costs of transactions (Joskow, 11150-151) (Posner and Rosenfield, p.88-89). The way that contract law effectively reduces the costs of contract negotiation and effectuates the desires of the contracting parties can best be analyzed and evaluated in terms of economic efficiency. An interesting problem that arises in contract law is related to the doctrine of impossibility, in which an unforeseen event either makes the contract physically impossible to perform or it makes the costs of a performance so much greater than the promisor’s benefits that it renders the performance of the contract impracticable. in some cases of impossibility, the promisor’s failure to perform the contract is excused. However, whether the courts should allow contract discharge or always treat the failure to perform as a breach of contract remains a subject of debate. The most economically efficient outcome in the case of impossibility is often unclear. An economic analysis in terms of risk bearing allows one to View the problem associated with impossibility horn a different perspective; it provides a rule that gives the right outcome to pet cases that involve impossibility. However, there are special circumstances under which such an analysis does not necessarily yield the most efficient outcome. These exceptions and problems associated with the impossibility doctrine are therefore discussed in length in this paper. The plan of this paper is in six parts: In part II, I introduce the concepts of impossibility and some of its related doctrines, namely commercial impracticability, frustration of purpose and uniform commercial code (UCC). In part III, I discuss the concepts of risk allocation and risk bearing, and how they can. be used to arrive at the correct outcome in the case of impossibility. i also discuss some of the typical cases of impossibility in which contract discharge is normally granted. In part IV, I discuss some of the arguments that support the claim that one should treat all unperformed contracts as breach of contract cases rather than discharge cases. In part V, I discuss the arguments for the impossibility doctrine and how the doctrine can provide incentives to promisees to make socially efficient reliance decisions without causing moral hazard. Part VI is the conclusion. Distinguishing between Impossibility, Commercial Impracticabiiity, Frustration of Purpose and Uniform Commercial Code (UCC) - The impossibility doctrine is invoked when it is economically sensible to discharge a contract due to an unforeseen event which makes the costs of performance of a contract exceed the benefits. However, it is not always easy for the court to decide whether granting contract discharge to a given case would yield the most economically efficient outcome. The fact that there exist other situations similar to the case of impossibility, such as commercial impracticability and frustration of purpose, filrther complicates the economic analysis of the impossibility doctrine, and over the years courts have extended the doctrine of impoSsihility beyond those instances of strict physical or legal impossibility (Wagner, pl). The first type of impossibility cases includes true physical impossibility and legal impossibility. in the case of true physical impossibility, performing the contract is determined to be physically impossible due to a supervening event that was not foreseeable to both parties to the contract (Posner and Rosenfield, p.85). For instance, the death of the promisor, who was contracted to perform personal services, or in the case where a particular item that is necessary for the performance of a contract has been destroyed by a fire or earthquake. in the case of legal impossibility, performance of a contractual duty might be possible, yet doing so would be against the law or a government order (Wagner, pl). The other category is frustration of purpose, in which performance of a promise is physically possible, but the underlying purpose of the bargain is no longer attainable (Po sner and Rosentield, p.86). An example of frustration is the well—known coronation case in which an apartment was rented to view the coronation procession of Edward VII. In this case, the coronation was canceled due to the fact that Edward developed appendicitis and discharge of the contract was granted by the court on the ground that the underlying purpose of the bargain, namely the viewing of the coronation procession, had been frustrated (White, p.369). in these frustration cases, discharge is often granted when the purpose of the contract is “frustrated” by events occurring subsequent to the time the contract was signed (Joskow, p.151). The third category is commercial impracticability where performance of the promise is physically possible and the underlying purpose of the bargain achievable, but because of an unexpected event, enforcement of the promise would end up entailing a much higher cost than what was originally contemplated (Posner and Rosenfield, 13,84). An example of this would be the famous the uranium market and the Westinghouse case, in which Westinghouse Electric Corporation, a major vendor of nuclear reactors and a major contractor for uranium fuel, failed to fulfill its contractual commitments to deliver uranium to its contracted partners. in the Westinghouse case, the company appealed to the Uniform Commercial Code (U.C.C.), which often excuses the promisor from the performance of contractual obligations for reasons of commercial impracticability, and argued that it was not legally bound to honor their contracts because for unforeseeable reasons the prices of uranium had risen to several. times the price of uranium at which the contract was made (Joskow, p.119). As mentioned earlier, the notion of impossibility has been widened in recent years to include both physical impossibility and commercial impracticability, and this generalization is adopted throughout this paper. In all these cases, there exist only two possible outcomes; the court will decide whether the non~performance in question should be treated under the doctrine of contract breach, in which the party that fails to complete the contract has to pay damages to the other party to the contract, or the court can treat the non-perfonnance as a discharge of the contract where the promisor has no obligations for any damages the non-performance might have caused to the promisee. in most cases, the court makes its decision between these two options based on the concepts of risk allocation and risk bearing in order to engender the most economically efficient outcome in the case of non-performance of a contract. Risk Allocation and Risk Bearing as the Basis for Achieving the Most Economically Efficient Outcome Whether one believes in the doctrine of impossibility or total liability, the two doctrines essentially deal with the same thing — the allocation of risks associated with performance of the contract between the promisor and the promisee. According to Posner and Rosenfield, regardless of whether one is dealing with an impossibility, irnpracticability or a fiustration case, the basic solution to the important question is, who should bear the loss resulting from an event that has rendered performance by one contracting party uneconomical‘? (Posner and Rosenfield, p.86). The concept of risk bearing can be analyzed in terms of risk neutrality and risk aversion. Risk averse people perceive risk as a great disutility. For example, suppose one can choose between two kinds of lotteries and the fees for playing in these two different lotteries are the same. One has a 50% chance of winning the first price $1 million if one chooses the first type of lottery or a 25% of winning a $2 million if one chooses the second type. Those who choose to play the first lottery are said to be more risk averse, because they are less willing to risk their money in exchange for a possible greater return. It is obvious that risk aversion is extremely common in our society as evidenced by the prevalence of insurance (Posner and Rosenfield, p.91). Indeed, insurance is essentially a mechanism by which one can trade the uncertainty of getting a risk for a certain cost. Therefore, it is clear why risk~averse individuals would pay more for insurance to avoid bearing risk than the expected cost of the risk, There are two ways of determining which party to the contract is the better risk bearer, namely evaluating their risk appraisal costs and their transaction costs (Posner and Rosenfieid, p.91). Risk appraisal costs include two components: the costs of determining the probability that the risk will materialize and the costs of measuring the magnitude of the loss if it does materialize. The amount of risk entailed by a non-performance is simply the product of the probability of loss and the magnitude of the loss. Both the probability and the magnitude of a risk must be determined in order to calculate the amount of compensation for hearing the risk in question. The other factor, transaction costs, are the costs invoived in eliminating or minimizing risk through diversification (Wagner, p.10). As mentioned before, this can he achieved through either self-insurance and market insurance. An example of self-insurance would he a corporation holding a diversified portfoiio of securities. By doing this, the corporation can eliminate the risk associated with some contract the corporation made which turned out to be impossible to fuitiil, because the corporation has shares in many other corporations whose earnings would not be affected by the non-performance of the contract. In addition, the corporation can aiso use market insurance to eliminate the risk by purchasing a business-loss insurance that would protect it from the consequences of a default on the contract (Posner and Rosenfield, p.92). In light of these costs associated with the concept of risk bearing, one can see why the anaiysis of “who is the superior risk bearer” plays a vital role in determining the outcome of a case that involves a supervcning, unforeseeable event. On the part of the promisee, contract discharge should be allowed if the promisee could have insured against the occurrence of the event at a lower cost than the promisor. This couid happen when the promisee is in a better position to estimate both the probabiiity of the event’s occurrence and the magnitude of the loss. Furthermore, discharge shouid also be granted if the promisor would have had to buy more costiy market insurance. Once the better risk bearer of the two parties is determined, he or she is also the better insurer of the two — an important criterion used for determining whether granting discharge or a breach of contract is the correct outcome, as we wiil see in several typical impossibility cases in the following section. Risk is assigned to the promisee when the law treats the faiiure to perform as excusable and discharges the contract, whereas it is assigned to the promisor when the law treats the failure to perform as a breach of contract. Some scholars believe that discharge should be granted where the promisee is the superior risk bearer or the party that is the more efficient bearer of the particular risk in question. In other words, he or she may be in a better position to prevent the risk horn materializing and is able to hear more cheaply the risk of the contract not being performed. Conversely, nonperforinance should be treated under the doctrine of breach of contract if the promisor is the superior risk bearer (Posner & Rosenfield, p.90). Discharge is only economicaliy efficient if the parties to a contract had sat down and agreed to adopt the terms supplied by the discharge doctrine. in a contract between a buyer and a seller, there can be four possible risk bearing situations: (1) both seller and buyer are risk neutral; (2) only the seller is risk neutral, whereas the buyer is risk averse; (3) the seller is risk averse and the buyer is risk neutral; (4) both seller and buyer are risk averse (White, p.357). It is clear that when the performing party is risk averse and the non-performing party is risk neutral, the damages caused by a non-performance is the smallest, whereas the damages are the largest when the performing party is risk neutral, regardless of the risk preferences of the non-performing party (White, p.375). The concept of risk bearing holds the key to understanding how courts decide between contract breach and contract discharge as we will see in the economic analysis of the following representative cases. Typical Cases which Invoke the Doctrine of impossibility There are five major classes of legal cases in which the doctrine of impossibility is often involved. They are: (l) contracts for personal services; (2) the effects of supervening illegality; (3) transportation contracts; (4) contracts for the supply of specialized equipment; (5) contracts for the supply of agricultural products; (6) grazing contracts (Posner and Rosenfield, p.101). Each of these six typical cases can be analyzed in terms of risk bearing to yield the most economically efficient outcome. In the first case, discharge of contracts for personal services is otten granted if the promisor, or the employee in this case, has died unexpectedly. This outcome is correct and is consistent with the economic approach for three reasons. First of all, the employee is not in a better position as the employer to estimate his life expectancy assuming the employee did not withhold information about his or her health condition that would reduce his or her life expectancy dramatically. If the performer of the contract, for example, has a tenninal disease such as cancer or AIDS, he or she would be obliged to disclose that information or the contract discharge would not be granted. Secondly, it can also he argued that the promisor has better knowledge of the value of the contract to him compared to that of any alternative employment, and therefore he or she knows better the magnitude of the loss if the contract is not performed. Some might also argue that the prorrrisor can purchase life insurance as a way of diversifying away the risk of not being able to perform the contract (Posner and Rosentielci, p. 100), however, this argument is unsound, since the compensation collected from the insurance company as a result of the employee’s death does not benefit the employee him or herself directly. Nevertheless, the employee is not the superior risk bearer in this type of personal services cases, and the failure to complete a contract due to the employee’s death often results in discharge of contracts. On the other hand, another typical personal services case in which discharge might not be granted involves an unexpected contingency that prevents the completion of the promised service. For example, in the historical case, Hein v. Fox, the promisor or the employee in this case was contracted to drill a well on the promisee’s land, yet due to war time regulations the promisor was unable to purchase the special tool used for penetrating the rock (Posner and Rosenfield, p.101). Other similar cases are often treated under contract breach in which the promisor must pay damages. The rationale behind the breach of contract outcome is that the promisor in these cases oflen has superior knowledge and more experience for the services performed, and is in a better position to estimate the probability of encountering a supervening event, in this case, a rock, which would render the completion of the contract impossible. in addition, the promise: is also in a better position in estimating the costs of alternative drilling techniques (Posner and Rosenfield, p.101). The same arguments can be applied here that support why the employee is indeed the superior risk bearer: the promisor or the employee in this case could have spread the risk of these contingencies among all of his or her customers in how much he or she Charges for drilling, which amounts to an effective and cheap way of self-insurance (Posner and Rosenfield, p.101), and therefore granting him or her discharge would not have given the economically optimal outcome. In the second class of impossibility cases, supervening illegality is the agent that causes the completion of a contract to be impossible. For example, a flu epidemic caused a school to shut down for nearly two months under the order of the state board of health. As a result, the school district had laid off the teachers at that school and argued that their contract with the teachers was discharge because it was legally prevented from performing it (Posner and Rosenfield, p.101). The outcome of the case was that discharge was not allowed, because the school district was the superior risk bearer for three reasons: it could spread the risk among all of its school and all of the teachers; it also had a diversified portfolio of schools. Furthermore, the school district could also have insured all of its employees in one transaction, thereby eliminating the need for each individual to incur transaction costs (Posner and Rosenfield, p.101). The third class, transportation contracts, include cases that are often due to unexpected events such as wars that render the completion of the transportation contracts uneconomical. Several litigations were filed as a result of the closing of the Suez Canal by the Egyptian government which caused ship passing between Atlantic ports and ports in the Middle East to take a longer route around Africa. In the famous case, Transatlantic Financing Corporation v. United States, the ship owner, which was the carrier, Transatlantic Financing Corporation in this case, was contracted to deliver wheat from the US to Iran for the United States, which was the shipper in this case. Again, in this case the carrier or the ship owner is the superior risk bearer, because they can better estimate the magnitude of the loss and the probability of the unexpected event (Posner and Rosenfield, p.104). They can also ship along several different routes, thereby spreading the risks of delay on any particular route. Furthermore, they could purchase a single transaction market insurance covering multiple trips (Posner, p.104). What is interesting about this case is that the shipper in this case, the United States Government, was also well-diversified. It can also he argued that the United States would have a better idea than the ship owner of the consequences of delayed arrival of its shipment, however, this type of consequential damages are not reient to the discharge question (Posner, p.105). The carrier cannot estimate damages that...
View Full Document

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern