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Law and economics and method analysis: the contractual damages issue

Guido Alpa [*] and Alberto Giampieri [**]

1. The contractual damages: common principles to civil and common law

With respect to the breach of contract, it is possible to indicate some common principles to the different law systems:

(i) the contracting party cannot avoid the performance of the contractual obligations without incurring in any negative consequence; (ii) the injured party cannot take advantage of the breach by generating a damage to the breaching party; (iii) the remedies to the breach of contract can be provided either by contract (e.g., penalty clause, etc.) or by the Courts; (iv) the latter include either the recovery of damages or the specific performance; (v) the recovery of damages includes the loss suffered by the injured party, as well as the loss of gains; (vi) in any case, the only recoverable damages are the foreseeable damages, except for specific cases; (vii) the moral damages, in principle, are not recoverable; (viii) the injured party should try to reduce the damages by acting in good faith; (ix) also the injured party is liable for damages (i.e., the damages incurred may be reduced), in case that same party contributed to cause them.

This "common core" of contract law has been correctly reflected and reproduced by Unidroit in its Principles of International Commercial Contracts (Rome, 1994, ch. 7, Non-Performance), in which the matter is divided into several general rules (Sec. 1: Non-Performance in General) and other rules related to the right to performance (Sec. 2: Right to Performance), to termination (sec. 3: Termination), to the recoverable damages (Sec. 4: Damages).

Similarly, the so-called Commission on European Contract Law, directed by Ole Lando, has drafted some common rules to different law systems (see, Towards a European Civil Code, Dordrecht, Boston, London, 1994; The Principles of European Contract Law, Lando and Beale eds., London, 1994).

Based on the above, it might be maintained that the aforesaid common core may offer the opportunity to create models of economic analysis which may be circulated, that is models which may be suitable for any law system.

However, even on the basis of a preliminary analysis, this experience seems to be frustrated by the different approaches taken by the common lawyers as opposed to the civilians, and vice versa.

2. The different approaches

The first diverting approach, the economic consequences of which cannot be addressed herein, refers to the criteria for the imputation of damages.

In French, German and Italian law systems, the imputability of contractual damages is based on negligence, whereas in common law systems the negligence of a breaching party is neutral. Even in the continental experience, the application of strict liability rules has been promoted (see, for example, P. Trimarchi, Sul significato economico dei criteri di responsabilità contrattuale, published in Alpa, Pulitini, Rodotà, Romani, Interpretazione giuridica ed analisi economica, Milan, 1992, p. 283 and following). However, the case-law is currently favorable to find the liability and, therefore, to award the recovery of damages only if the breach of contract is caused at least by negligence.

The second, and more relevant for our purposes, different position pertains to the so-called "voluntary breach". The contracting party has no choice between performance and breach of contract: same party must, in any case, fulfill the obligation, except in case the breach is caused by force majeure, upcoming impossibility, unbearable upcoming material disadvantage, that is by causes independent from the party's willingness, interests, or business organization.

The voluntary breach, under the continental law systems, is negatively considered by the legislators: under the Italian Civil Code, art. 1225 provides that "if the breach or the delay does not depend on debtor's fraud, the recovery is limited to the damage which could be foreseen at the moment in which the obligation has been undertaken"; this is an ancient rule, which was already included in the French Code Napoleon (see, art. 1150: "Le debiteur n'est tenu que des dommages et interets qui ont été prevus ou qu'on a pu prevoir lors du contrat, lorsque ce n'est point par son dol que l'obligation n'est point executée").

There are several reasons for such approach: (i) first of all, the need to confirm the binding effect of the agreement; if the debtor could be in breach being subject to the sole recovery of damages, and same may obtain an advantage by performing the obligation undertaken in favor of a third party, there would not be any certainty in the contractual relationships: anyone, who has carried out a transaction and, therefore, has entered into an agreement, would not have the certainty of the effectiveness of the transaction and, therefore, of the obligation, since he would always be subject to a possible breach of the other contracting party; the breach of contract is considered as an exceptional event, connected with events not influenced by the expectactions of the party who is in breach; (ii) secondly, from a general point of view, the need to ensure a correct performance of the trade transactions; the operators, being subject to the risk of potential breaches of contract, could be induced not to enter into any trade transaction lacking a certain degree of certainty; (iii) the need to moralize the market, in which good faith and fair dealing are the standards to which the operators should conform; (iv) the need to reduce the costs of the transactions, since the parties, foreseeing potential mutual breaches, can either contractually provide for the possible relevant remedies (such as penalty clause, termination, etc.), or obtain bank guarantees or insurance policies, etc.; all the above being useful, but expensive remedies; (v) the specific performance is deemed not as a residual remedy, but as a natural remedy.

On the contrary, in common law systems, the Holmes statement: "The 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" (The Path of the Law, 1897, Harv. L. Rev., p. 462) is fundamental.

English and North-American scholars and case-law are consistent in holding that the voluntary breach of contract is not to be sanctioned with remedies different from those typically provided under contractual structures.

In English common law, Collins, in a comment to Holmes, notes that "although this dictum exaggerates the extent to which orders for compulsory performance are excluded from actions for breach of contract, it does indicate how damages are quite frequently the sole option for the injured party. The question to be addressed here is how of damage is calculated" (The Law of Contract, London, 1993, p. 372); and, in North-American common law, Farnsworth states that "the skeptical reader may well ask whether persons of judical temperament are immune from the temptation to depart from a rule oblivious to blame, and some exceptions to the rule will be suggested in the pages that follow. Nevertheless, contract law is, in its essential design, a law of strict liability, and the accompanying system of remedies operates without regard to fault" (Contracts, Boston-Toronto, 1982, p. 842).

The reasons for this disregard to voluntary breach are several: (i) in common law the breach of contract is not generated by, and is not connected to negligence of the breaching party; (ii) in common law a factual approach prevails on a moralistic approach to the matter: any transaction implies certain risks, and whoever penetrates a market and operates on it must bear the risk of other parties' breaches; moreover, if he allocates his products or services to different parties for more convenient prices, he is in breach and fulfill the obligations undertaken with third parties; (iii) the same market rules request a better allocation of the resources and, therefore, the sanction imposed on the breaching party is represented only by the contractual remedies pursuant to the principle of the "efficient breach"; (iv) the party who is not prepared to run the above risks, may take advantage by entering into ad hoc clauses (such as a penalty clause, etc.) with the other contracting party.

Therefore, from a law and economics viewpoint, the above position is the starting point for further developments.

3. Law and economics and voluntary breach

The law and economics scholars are inspired by Holmes. For example, Posner notes that: "When a breach of contract is established, the issue becomes one the proper remedy. A starting point for analysis is Holmes view that is not the policy of the law to compel adherence to contracts but only to require each party to choose between performing in accordance with the contract and compensating the other party for any injury resulting from a failure to perform. This view contains an important economic insight." (Economic Analysis of Law, Boston-Toronto, 1977, p. 88).

In accordance with the above reasoning, Cooter and Ulen, in turn, state: "We define an efficient breach as follows: a breach of contract is more efficient than performance of the contract when the costs of performance exceed the benefits to all the parties".

"In summary, breach is efficient when, as a result of a windfall or an accident, the resources needed for performance are more valuable in an alternative use. Incentives for breach are efficient when the transfer of resources to the highest-valued use is accomplished at the lowest transaction costs and in such a way that no one is made worse off by the transfer and at least one person is made better off." (Law and Economics, 1988, p. 290-291).

Therefore, the same damages raise issues with respect to the circulation of the relevant economic models: it is even possible to agree with Posner, Cooter, Ulen and all the scholars who analyzed the above issues; however, in the civil law experience, such models remain abstract and inapplicable arguments.

4. Models of damages assessment

Even with regard to the assessment of damages, the common law and civil law systems provide for different options. We have outlined above the analogous solutions provided for with reference to the recovery of any loss suffered by the injured party and the loss of gains.

However, these general principles imply two different methods of assessment. The most common method consists in considering the injured party in the position in which same party would have been, if the agreement had been properly fulfilled (so-called Diferenztheorie: see, par. 249 of B.G.B., pursuant to which "a person who is obliged to make compensation shall restore the situation which would have existed if the circumstance rendering him liable to make compensation had not occurred"). This theory is adopted in France and in Italy, as an addition to the text of the Codes (see, respectively, art. 1149 and art. 1223), which generally make reference to the loss suffered by the injured party and the loss of gains.

Even common law systems adopt the above indicated method, which is known as recovery of damage consisting in the so-called expectation interests. In English law, without further case-by-case explanations on the application of the rule, it is possible to select categories of damages analogous to those pertaining to the civil law experience (see, for example, Treitel, The Law of Contract, London, 1991, p. 824 and following); the same conclusion is applicable with reference to the U.S. law system (see, for example, Farnsworth, cited above, p. 839 and following).

However, a second method (the so-called reliance interests), which is based on the recovery of damages considering the position which the injured party would have had if same had never enter into the agreement, has been adopted for some decades.

The above method is not permitted in the civil law systems. In Italy, such a method is applied only with respect to the negotiations (so-called "pre-contractual liability"), when either of the parties has withdrawn from the negotiations without a valid reason, or has caused a ground of invalidity of the agreement to be entered into.

Therefore, the whole argument concerning the reliance interests is not applicable to the civil law systems.

The Unidroit Principles, in order not to limit the options of the judges/arbitrators, have not taken any position in point: the harm "includes both any loss which [the injured party] suffered and any gain of which it was deprived" (art. 7.4.2).

5. Applicable law

The considerations on the double recovery method (available to common lawyers but not to civilians) are useful for a practical reason: in case of possibility of choice of the law applicable to the agreement, it would be preferable to subject same to either a civil law system or a common law system depending on the willingness to exclude the recovery of reliance interests or to admit them (at least, in principle).

However, even in this case, it is clear that the law and economics, as far as the civil law systems are concerned, must be limited to the first method: the second could be taken into consideration only in case of either a legislative amendment or a completely different approach of the case-law rules, which seems to be, for the time being, a very unlikely event.

6. Conclusions

The analysis of some of the rules related to the breach of contract and the relative damages recovery techniques shows that the models of law and economics cannot be always applied: they are always based either on a certain law system or on legal concepts typical to a peculiar experience; the adoption of a perfect, ideal, abstract model may be useful as a general framework, but, in order to achieve practical results, it is necessary to carry out an analysis in light of the applicable law, taking into account the interpretation given by the jurisprudence and the concepts on which same is grounded.


FOOTNOTES

* Professor of Private Law at University of Rome "La Sapienza".

** Lecturer of Private Law at University of Rome "La Sapienza".


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