Teaching Assistants: Victor Goldberg on the Flexibility/Reliance Tradeoff

This is the second in a series of posts on Victor Goldberg's work.  Today's post is about Chapter 2 of his book, Rethinking Contract Law and Contract Design (RCL).

The introductory post is here.

In teaching contracts, we often keep things simple, focusing on familiarizing students with doctrinal rules that they will likely need to know to pass the bar exam.  In the world of contracts as illustrated in contracts casebooks, both parties enter the contract assuming that both will perform, and then, for some reason, one party breaches.  Contracts doctrine instructs us that the non-breaching party ought to be made whole and be awarded damages equal to the non-breaching party’s expected benefit from full performance.

But in contracts between sophisticated parties that may take a while to perform, the possibility of incomplete performance can be a structural component of the deal.  Contracts involve a trade-off between the parties desire for flexibility and their reliance on the continuation of the contract.  Parties can negotiate an early exit, but there may be no express provision in the contract that addresses the dynamic between flexibility and reliance.  Professor Goldberg addresses this dynamic in four different contractual contexts, and the result is rarely that the non-breaching party is entitled to the benefit of the bargain (RCL 9-10).

Venture capital deals are created to allow the venture capitalist (VC) to opt out of further funding if the venture is unpromising but to protect its investment through an option to pursue a second round of investment on more favorable terms than other potential investors.  The entrepreneur’s reliance interest is protected because the VC would suffer reputational harm if it abused its power to terminate the relationship to extract more favorable investment terms after the first round of investment (RCL 10-11)

Illusory contracts can be viewed as sitting at one extreme of the flexibility/reliance dynamic.  For example, as Professor Goldberg illustrates with a discussion of Bushwick-Decatur Motors, Inc. v. Ford Motor Co., Ford preferred to enter into franchise agreements with its dealerships that were terminable at will.  Notwithstanding oral representations to the contrary, the district court found that Ford clearly reserved the right to terminate the relationship at any time, regardless of reliance.  Other car manufacturers did not go quite so far, but allowing for termination on fifteen-days notice was effectively pretty much the same as an unenforceable agreement.  Eventually, legislators moved in to protect the dealers (RCL 11-12).  Professor Goldberg finds similarly illusory contracts between General Motors and one of its main parts suppliers and between Kellogg’s and its main packaging supplier.  Neither party has any motivation to breach because both are reliant on the other, but both presumably want the flexibility to shop around should the opportunity arise (RCL 12-13).

The reliance/flexibility dynamic can lead to express terms in the context of breakup fees in connection with corporate acquisitions.  A lot can go wrong and a lot can change between the negotiation of a corporate acquisition and its closing.  As a result, the buyer will want to negotiate the option to walk away.  It needs flexibility.  However, the seller relies on the deal going through, and so the parties have to negotiate what, if anything, the buyer would have to pay to walk away.  One option is a three-tiered system, as in Hexion Specialty Chemicals, Inc. v. Hunstman Corp.: in the event of a material adverse change in the value of the seller, the buyer could walk away for free; in the event the buyer was unable to finance the acquisition, $325 million; and in case of bad acts by the buyer, no cap on damages.  After the Delaware Chancery found bad acts by the buyer, the buyer settled by paying $1 billion (RCL, 13-14)

Finally, Professor Goldberg discusses pay or play movie deals and professional athletes’ or coaches’ severance packages.  In both cases, a star actor, director, player, or coach can command protection in the form of a termination/severance payment.  An actor might be guaranteed $20 million, subject to an offset if she finds alternative work, or a comparable part in another production (RCL, 15)  A star coach or player might command liquidated damages without a duty to mitigate, although earnings in a new position might be used to offset damages (RCL 16).

In light of these examples, Professor Goldberg suggests that contracts entail an option to breach and the cost of exercising that option is whatever remedy is available, either through the parties’ private arrangement or through the law of contracts damages (RCL 16-17).  Sophisticated parties are well positioned to negotiate the price of exit, and they may fashion whatever remedy reflects their competing interests in flexibility and reliance.  And yet, legal scholars and courts resist following Holmes by treating breach as an option.  In part, this is an instance of the stickiness of doctrine that I referenced in the introductory post.  In part it is a product of a rhetoric attaching moral opprobrium to breach. If a breach is a wrong, corrective justice requires that the non-breaching party be made whole.  (RCL 18-19).  Finally, Professor Goldberg illustrates, through his option framework, the error of the common assumption that contracts damages under-compensate because they do not account for lost profits.  Parties left to their own devices can set the price of breach as they choose (RCL 20-21).

I note that Professor Goldberg’s work finds support in some recent empirical work that Mitu Gulati (right) undertook with his students and which we featured on the blog here and here, and Professor Goldberg work is cited in their “Lipstick on a Pig” article.