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Friday, May 27, 2005

Analyzing remedies

There's been a lot of law-and-economics exploration of contract remedies, but relatively little of it focuses on one aspect of the situation: the fact that remedies are cumulative and the party has a choice of which one to follow.

That's the thesis of Northwestern's Ronen Avraham (Law) and Zhiyong Liu (Management), in a new paper, Incomplete Contracts with Asymmetric Information: Exclusive v. Optional Remedies.  Click on "continue reading" for the abstract.

ABSTRACT

Law and economics scholars have always had a strong interest in contract  remedies.  Perhaps the most explored issue in contract law has been the desirability of various contract remedies, such as expectation damages, specific performance, or liquidated damages, to name the most common.  Scholars have been debating for years, from various perspectives, the comparative advantage of these remedies.  Yet, most scholars have assumed that each of these remedies is exclusive, and their work has compared a single remedy contract to another single remedy contract.  Interestingly, an analysis that assumes these remedies are optional (or cumulative) has not yet been explored, in spite of the fact that contract law provides the non-breaching party with a variety of optional remedies to choose from in case of a breach, and in spite of the fact that parties themselves write contracts which provide such an option.

In this paper we attempt to start filling in this gap by studying the relationship between these remedies.  Specifically, we study the conditions at which a contract that grants the non-breaching party an option to choose from optional remedies is superior to an exclusive remedy contract.  We show that under conditions of double-sided uncertainty and asymmetric information between a seller (who might breach) and a buyer (who never breaches) the interaction of the parties' distributions should determine whether a contract provides for exclusive or optional remedies.  Specifically, if the buyer's conditional expected valuation is larger than the seller's conditional expected valuation (in both cases - conditional that their expected valuation is above the buyer's mean valuation), then a contract which provides the buyer an option to choose between liquidated damages or specific performance (or actual damages) is superior. 

Our analysis in this paper informs transactional lawyers of the relevant economic factors they should consider when deciding the optimal composition of remedies in a given context.  Moreover, our analysis is relevant for courts that interpret contracts because it will help them to better understand whether rational parties would have agreed that a particular remedy would be an exclusive remedy or an optional remedy when the language of the contract is ambiguous.  Lastly, our analysis provides yet another economic rationale for why courts should enforce parties' liquidated damages clauses even if it seems ex-post over, or under, compensatory.

We present a model which shows when parties will agree on a non-exclusive liquidated damages clause.  Under such a contract the parties stipulate ex-ante that the buyer will have the option to choose upon breach whether she prefers an optional remedy, such as actual damages or specific performance, to the pre-determined liquidated damages.

We focus on the ex-ante design of the contract in light of the new information that the parties  anticipate they will gain after they draft the contract.  Therefore, we assume that no renegotiation or investments are involved.  We demonstrate the optimal way to design contract clauses which takes advantage of the information that the seller and the buyer receive between the time they enter into the contract and the time of the actual breach.  We further suggest that parties indeed use such clauses and that courts honor them.  After laying out the basic model we provide some extensions to it.  As is well known, an exclusive liquidated damages contract is equivalent to granting the seller a call option to breach and pay, where the exercise price is equal to the amount of the agreed liquidated damages.  What is perhaps less known is that a non-exclusive, or optional, contract, where the buyer can choose performance, is equivalent to giving the buyer a consecutive call option with the same exercise price.  Yet, the consecutive call option to the buyer does not have to have the same exercise price but can rather have a higher one.  We call this new contract a two-price contract and show that it is even more efficient than the basic contract we have explored before.  Next, we introduce more rounds of sequential options and show that while the regular ex-ante contract can achieve on average about 4 Indeed, in an environment of asymmetric information renegotiation costs are high.  More on this below.  90% of the first-best allocative efficiency, an n-rounds contract approaches the first best, as n goes to infinity.  We show numerically that within just 4 rounds, 96% of the allocative efficiency can be achieved.

Section two describes the legal background against which we have designed our model.  Section three surveys the literature that evaluates contract remedies from an economic perspective.  Section four presents a simple model with two-sided incomplete information and with a liquidated damages clause.  In section four we compare the performance of a regime with optional remedies with a regime of exclusive remedy and then determine the conditions at which each regime should be applied.  Section five discusses some interesting extensions meant to approach the first-best allocative efficiency.  The appendix provides a more rigorous mathematical demonstration of the model.

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