CONTRACTS AND THE DOCTRINE OF EFFICIENT BREACH
Snehal Bade
Introduction
The notion of contracts is an ancient one dealing with law, society, economics and business. The concept of capacity to contract led to recognition of concepts of ownership, possession, transfer, etc. Contracts have now become a way of living. The principles of contract and laws of contract are the backbone of commerce, industry, agriculture and economy of every country. A contract entails both rights and obligations. These obligations may not only be legal but also include those backed by social and moral sanctions. We have studied and applied innumerable principles of contract in different circumstances with a view to achieve varied desirable results. Some of these principles relate to “breach of contract”.
This article proposes to discuss the concept of “breach of contract” in the light of the said doctrine of efficient breach. It has been discussed at length by many judges and jurists in England and the United States of America. This term needs to be explored in the Indian context.
I. Definition and Meaning
The development of contracts law with regard to economics and business methods is still in its nascent stage.
To begin with, the term “efficient breach” is employed in cases of breaches that are socially and economically beneficial. It refers to an international “breach of contract” and payment of damages by a party who would incur greater economic loss by performing under the contract.[1] Efficient breach theory is “the view that a party should be allowed to breach a contract and pay damages, if doing so would be more economically efficient than performing under the contract.”[2] Basically, efficient breach theory is the common law remedy of expectation damages. This remedy requires a party who breaches a contract to pay damages in an amount that would make the victim of breach as well off as he would have been had the breach not occurred. In principle, this gives each contracting party an incentive to perform when performance is efficient, but not otherwise. Parties will therefore complete those contractual projects that are valuable and abandon those that are wasteful.[3]
Indian law does not define the term ‘breach’. Breach means a failure to do something that must be done by law.[4] ‘Effiecient’ cannotes the doing of something well and thoroughly with no waste of time, money or energy.[5] Thus on a combined reading we can conclude that when the avoidance of a contract becomes more beneficial and economical than its performance, then such a breach is called an ‘efficient breach’. Contract law and efficiency theory both asserts that society benefits from the non-performance of some promises.
II. Application
The application of the Efficient Breach Theory can be demonstrated with the help of some illustrations.
Illustration 1
The owner of a land makes an agreement with a building contractor for construction of a building within 6 months. The total cost of the contract is set as Rs. 25 lakhs. Out of this amount, Rs. 20 lakhs is the actual cost for construction accounting for the material used, labour employed and other related factors. He does work worth Rs. 5 lakhs. In the meantime the cost of construction goes up by Rs. 10 lakhs owing to an inflating market. The contractor thus has to suffer a loss of Rs. 10 lakhs because the term of the contract cannot be altered subsequently.
A term in the contract reads that in case of breach committed by the contractor, he shall be liable to pay the contract price in addition to Rs. 5 lakhs as damages i.e. Rs. 30 lakhs in total. During this time he gets an offer from another owner of some other land to construct a building for Rs. 75 lakhs. This owner is under an obligation to get the work of construction within a specified period. If he fails, he will have to pay huge amounts of money as damages for breach. The actual cost of construction comes out to be 30 lakhs (the same amount which he would have spent had he performed his earlier contract post inflation) taking into consideration the fluctuating market. He thus has an option to efficiently breach his first contract. If it does so, under the second contract he will gain a profit of Rs. 45 lakhs. After deducting the amount of damages and Rs. 5 lakhs i.e. the amount that he has already spent while performing his earlier obligation, the contractor will still earn a profit of Rs. 10 lakhs.
In this way, what was his loss earlier now becomes his profit. At the same time, the aggrieved party is getting damages due under the contract and the amount is enough for it to get the work done by some other person. Even if the aggrieved party goes to the court, there would not be much interference with the measure of damages since the parties have themselves provided for it on their own violation. In addition, the case does not qualify to be one of specific performance, since damages are measurable. Also, the owner in the second contract is in no way affected by these transactions. This can be termed as a win-win situation for every party.
Most importantly, the contract will still be entitled to get the value of materials, although not the amount for working, for whatever amount of work done in pursuance of the prior contract.[6] Professor Craswell explains the purpose of efficiency breach:
“If a breaching seller must pay damages equal to the value of the goods to the first buyer, the seller will find it profitable to breach the contract only if the second buyer is willing to pay more than that amount. This will be possible only if the second buyer values the goods more than the first buyer does, and in that case the breach will be efficient because it will move the goods to a more highly valued use.”[7]
In economic terms, this kind of breach is Pareto Efficient. In a given a set of alternative allocations of, say, goods or income for a set of individuals, the contract in the present case, a movement from one allocation on to another that can make at least one individual better off without making any other individual worse off is called a Pareto improvement.[8] In Law and Economics, Robert Cooter and Thomas Ulen describe the Pareto Superior event: “A transaction is said to be Pareto efficient if it is possible to change it so to make at least one person better off (in his own estimation) without making another person worse off (again, in his own estimation).”[9] With facts in the above illustration, no party in being subjected to financial loss.
Illustration 2
Let us now consider the centrepiece illustration of the theory of efficient breach in the first edition of Posner’s Economic Analysis of Law:[10]
“…I sign a contract to deliver 1000,000 custom-ground widgets at $0.10 a piece to A, for use in his boiler factory. After I have delivered 10,000, B comes to me, explains that he desperately needs 25,000 custom-ground widgets at once since otherwise he will be forced to close his Pianola factory at great cost, and offers me $0.15 apiece for 25,000 widgets. I sell him the widgets and as a result do not complete timely delivery to A, who sustains $1000 in damages from my breach. Having obtained an additional profit of $1250 on the sale to B, I am better off even after reimbursing A for his loss. Society is also better off. Since B was willing to pay me $0.15 per widget, it must mean that each widget was worth at least $0.15 to him. But it was worth only $0.14 to A--$0.10, what he paid, plus $.04 ($1000 divided by 25,000), his expected profit. Thus the breach resulted in a transfer of the 26,000 widgets from a lower valued use to a higher valued use.”
These are two ideal illustrations of the application of the doctrine of efficient breach.
III. Conditions for the application of the doctrine
Studying the above two illustrations, we can summarize that the following are the possible conditions necessary for the application of this doctrine:
- There should be demand of the goods or the service in the market.
- It should be valued at a higher price.
- The seller should be able to convert his loss into profit because of the breach.
- The seller should pay to the first buyer damages and the quantum of such damages should justify the buyer’s expectation losses.
- The seller should be in position to avoid any kind of litigation claims in the nature of specific performance.
- The third party should be immune from any litigating claims from the first buyer.
The legal remedies available to a buyer are vital to determine whether the contract is fit for efficient breach. However, as stated earlier, in a contract specifying liquidated damages, efficient breach is possible.
IV. Applying the Doctrine under Indian Law
An anticipatory breach occurs when the promisor absolutely repudiates the contract before the promised date of performance.[11] It is an announcement by a contracting party of his intension not to fulfil the contract, or that he will no longer be bound by it.[12] Number of reasons may compel or influence the promisor in deciding to breach the contract before the date fixed for performance. The extent of liability to pay damages can be foreseen by a reasonable man, as arising naturally in the course of things. Since economic and financial aspect is a major factor influencing the adherence of contracts, a party can breach the contract if the performance of a contract is patently uneconomical for either of the parties.
Contract law contemplates many kinds of damages viz. nominal, liquidated, exemplary, penal, damages for pain and suffering, etc. The doctrine of efficient breach can be seen best to apply to a contract which contains a clause specifying liquidated damages. Parties can predict the loss they might suffer and in case of breach, the amount of damages is well within the contemplation of the parties. It can thus be decided whether the breach will be efficient or not. When the amount has not been mentioned and if a suit is filed as a result of the breach, then the decision as to the measure of damages is at the discretion of the Court. In such a case, the party who is planning for an efficient breach will have to start from scratch, calculate the amount of damages arising in the usual course of things, as well as amount for unexpected situations. Thus a clause specifying for liquidated damages acts as an advantage to use the doctrine of efficient breach. However, this does not mean that every contract that specifies for liquidated damages is bound to be efficiently breached.
Many Indian judgments explain various aspects of award of damages, measure of damages, etc. However, there is no reported judgment expressly recognising this doctrine.
V. Issue of Morality
This doctrine is criticised as being against morality and principles of equity. To quote Oliver Wendell Holmes, “[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it,- and nothing else.”[13] This has generally been interpreted to mean that a contracting party has a lawful option to perform or not. Clerk Remington wrote, “[t]he law has come to regard the obligation to perform a contract as being generally equivalent to an option to perform or pay damages.”[14] Sir Frederick Pollock says “Mr. Justice Holmes…suggests that every legal promise is really in the alternative to perform or to pay damages: which can only be regarded as a brilliant paradox. It is inconsistent not only with the existence of equitable remedies, but with the modern common law doctrine that premature refusal to perform may at once be treated as a breach.”[15]
VI. Conclusion
Parties make contracts with an expectation of performance, of their own, and that of the other party. Promises are made to be kept as far as possible. If the Court imposes any exemplary damages as a penalty for the breaching party, then such a penalty can be treated as a charge for choosing to breach the contract. The law as it stands today provides parties an option of performance or breach. In such a case a party choosing the latter option should not be regarded acting against the law. There is a nexus between the conduct of a breaching party and the doctrine of estoppel, because promising first and then breaching it is against the principle of estoppel. However, the option for efficient breach is given by law and its exercise cannot be termed immoral.
[2] Bryan A. Garner (Editor-in-Chief), Black’s Law Dictionary, 8th Ed., Thomson West Publication, p. 555
[3] Barry E Adler, ‘Efficient Breach Theory through the Looking Glass’, Law and Economics workshop, University of Berkeley, 2007, available at http://repositories.cdlib.org/be_law_econ/Fall2007/18
[4] A S Hornby, Oxford Advanced Learner’s Dictionary of Current English, 6th Ed., Oxford University Press, p. 141
[5] Id. At p. 402
[6] Stumper v. Hedges (1898) 1 QB 673 C.A.
[7] Melvin Eisenberg, ‘The theory of Efficient Breach And The Theory Of Efficient Termination’, Law and economics Workshop, University of California, Berkeley, Paper 14, 2004, available at http://repositories.cdlib.org/berkeleylaw econ/spring2004/14 quoting Richard Craswell, ‘Contract Remedies, Renegotiation, and the Theory of Efficient Breach’, 61 S. Cal. L. Rev. 630 at pp. 634-35 (1988) –“…seller will find it profitable to breach the contract only if the second buyer is willing to pay more than that amount”, where ‘that amount’ refers to damages. This will be possible only if the second buyer values the goods more than the first buyer does, where ‘this’ apparently refers to Seller’s willingness to pay enough to make the breach profitable to Seller.”
[8] ‘Pareto Efficiency’, http://en.wikipedia.org/wiki/Pareto_Efficiency. Last visited on 21/02/2009; The term Pareto Efficient is used after the name of Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.
[9] Robert Cooter & Thomas Ulen, Law and Economics, Pearson Education Publication, 2004, pp. 16, 17
[10] Supra note 8
[11] Avtar Singh, Law of contracts and Specific Relief, 8th Ed. (2002), Eastern Book Company, p. 372; quoting ‘A Suggested Revision of the Contract Doctrine of Anticipatory Repudiation’, (1954), Yale Law Journal 85
[12] Id. At p. 372
[13] Dawinder S Sidhu, ‘The Immorality and Inefficiency of an Efficient Breach Transactions’, The Tennessee Journal of Business Law, vol. 8, p. 4; available at http://ssrn.com/abstract=936223
[14] Joseph M. Perillo, ‘Misreading Oliver Wendell Holmes on Efficient Breach and Tortious Interference’, 2000 Fordham Law Review, Vol. 68, p. 2; quoting Clark Remington on ‘International Interference with Contract and the Doctrine of Efficient Breach: Fine Tuning the Notion of the Contract Breacher as Wrongdoer
[15] Id. At p.3; quoting Holmes-Pollock Letters, ‘ The Correspondence of Mr. Justice Holmes and Sir Frederick Pollock’, 1874-1932
Pretty impressive ma'am!! You seem to be more into business/corporate law right?
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