Ex ante versus ex post expectation damages

Abstract

What information should courts utilize when assessing contract damages? Should they award damages that were rationally foreseeable at the ex ante stage (ex ante expected damages)? Or should they award damages at the ex post level, incorporating new information revealed after contracting (ex post actual damages)? In practice courts have varied between the two approaches, awarding damages equal to the lower, or the higher, of the two measures of damages. This article shows that ex ante expectation damages are more efficient than ex post actual damages through a simple model of costly litigation for contract breach, where there are either costs of verifying the breach victim's ex post damages, or general litigation costs such as attorneys’ fees. Courts should award foreseeable flat damages, rather than seeking ex post accuracy and awarding actual damages, because actual damages lead to distortions in breach incentives once we take parties’ litigation decisions as endogenous. With costly litigation, ex post expectation damages may cause over-performance or under-performance depending on whether the American or the English rule applies and on the size of the litigation cost. We find that regardless of the direction of the distortion, actual damages induce inefficiency. Ex ante damages are more efficient because of the insensitivity of parties’ litigation decisions to their ex post private information under fixed damages. Our results are robust when accounting for renegotiation.

Introduction

Imagine A breaches a contract he signed with B, but it turns out that the contract would have been a losing contract for B. Can B still recover damages from A? On the one hand, A after all breached the contract and should pay the foreseeable damages to B. On the other hand, B ended up suffering no loss, in fact she may have even benefited from the breach!

In the famous case of Bush v. Canfield,¹ the seller failed to deliver barrels of superfine wheat flour which the buyer agreed to purchase at $7 per barrel. It was proven in court that on the day of delivery, May 1, 1812, the price fell to $5.50 per barrel. The Supreme Court of Errors held it did not matter whether the buyer would have benefited from the breach ex post, what mattered when the seller breached was an ex ante evaluation of the damages. More modern cases have come to similar results.²

On the other hand, different courts have held that if a contract breach does not harm the other party when viewed ex post, then there can be no damages. In another case frequently assigned in first-year contracts classes, Acme Mills & Elevator Co. v. Johnson, the Kentucky court found that because the price of wheat on the open market at the time of delivery ($.975 per bushel) was less than the contract price ($1.03 per bushel), the buyer, Acme Mills, suffered no actual damages from the seller's breach and should therefore not be compensated.³ Other courts have reached similar conclusions.⁴

These examples challenge us to consider what information courts should utilize in assessing contract damages: should they award damages equal to the ex ante rationally foreseeable level (ex ante expected damages), or should they award damages at the ex post level, taking into account new information revealed after contracting (ex post actual damages)? As revealed in the above cases, courts vary between the ex ante and the ex post measures of expectation damages. But courts have done worse than just randomly choosing between the two measures. In the past, courts used the ex ante measure as a “floor” which over-compensates non-breaching parties with low ex post losses, but where parties with large losses are allowed to recover their actual ex post losses. We call this the “higher of the two” approach, and that seems to be the approach taken by the 1932 Restatement (First) of Contracts.⁵ In contrast, the 1981 Restatement (Second) of Contracts employed the “lower of the two” approach.⁶ If the foreseeable damages are lower than actual damages, courts often limit the award to the foreseeable damages. The rule of Hadley v. Baxendale is just one famous manifestation of this principle. However, if the foreseeable damages are higher than actual damages, courts often award only the lower actual damages. This principle is embedded, for example, in the penalty doctrine for liquidated damages which adjusts down stipulated damages if the actual harm manifested is lower. More generally, it is reflected in the compensation principle, which encourages courts to seek accuracy in awarding damages in order for the promisee to recover the full amount, and only the full amount, reasonably necessary to make him or her whole.⁷

We analyze the efficiency of the two damages measures through a simple model of contract breach, accounting for litigation costs such as attorneys’ fees or costs associated with verifying the breach victim's actual damages. In our model, parties sign a contract for trading an indivisible good or service, whose valuation to the buyer and cost to the seller are random at the time of contracting, but their distributions are common knowledge. Later, the buyer learns the valuation, and the seller learns the cost, but both will be private information. The seller then decides whether to breach, and if the seller breaches then the buyer decides whether to sue. Litigation is costly, and we will consider both the American and English rules. We recommend that generally courts should ignore ex post information and commit to simply awarding ex ante expected damages. Thus, courts should abandon either the “lower of the two” or the “higher of the two” approach. In the example above, B should recover damages foreseeable at the time A and B entered the contract even though her actual damages are zero (in fact negative!).

Our recommendation might look obvious because of informational costs to enforce the remedies. When the distribution of potential damages is common knowledge (as we assume in this paper), the ex ante expectation damages (simply equal to the mean of the foreseeable distribution of damages) have a much lower informational requirement, saving courts and parties the costs associated with verifying the plaintiff's actual harm (Avraham & Liu, 2012). Sometimes, however, especially if a thick market exists, it might be cheaper to verify the plaintiff's actual harm (when ex post market prices are readily available and it is difficult to determine the ex ante foreseeable harm). In such cases the ex post regime might be better.

Our recommendation that courts use the ex ante expectation damages measure is not just based upon the informational costs advantages. More interestingly, it is based on incentives grounds. Specifically, we argue that the ex post expectation damages regime induces self-selection among victims of breach with respect to the decision of whether to litigate the breach, and this self-selection effect (which does not exist under ex ante expectation damages) leads to distortions in performance incentives and hence inefficiencies. Victims with zero (or negative) actual damages would choose to not sue because their payoff from litigation would be nil. This option to not sue embedded in actual damages has two countervailing effects on breach incentives, only one of which was identified in the literature before. First, there is the missing zero-loss plaintiffs effect (discussed in Avraham & Liu, 2012) where the low end of the distribution of potential plaintiffs is truncated because victims whose actual losses are zero or negative choose not to litigate. As a result, the breaching party faces expected damages with a mean⁸ higher than the mean of the original damages distribution (the distribution under the assumption that all victims could be potential plaintiffs). Hence, interestingly, the missing zero-loss plaintiffs effect leads to over-performance.

The other effect, which was not discussed in Avraham and Liu (2012), is the missing medium-loss plaintiffs effect which occurs when litigation is costly. Under the ex post expectation damages regime the breaching party avoids liability to victims with medium losses as those victims choose not to sue even though their losses are positive because, given litigation costs, their expected net recovery is negative. The missing medium-loss plaintiffs effect leads to under-performance.

How would the over-performance (due to the missing zero-loss plaintiffs effect) and under-performance (due to the missing medium-loss plaintiffs effect) play out? Whereas in Avraham and Liu (2012) we argued that ex post expectation damages will always lead to over-performance, we show here that with costly litigation ex post expectation damages can also lead to an equilibrium of under-performance. Nevertheless, no matter which direction of distortion to the performance incentives (over- or under-performance) that the ex post expectation damages would induce, the distortion renders the ex post damages inferior to the ex ante expectation damages.

Our model endogenizes the non-breaching party's decision of whether to litigate based on the information revealed only ex post. The large volume of previous literature on comparative efficiency of contract remedies typically assumes an informational structure such that the breach victim will always sue for a certain type of remedy.⁹ This assumes away the possibility that a privately informed, non-breaching party may choose not to file a lawsuit if the expected payoff from litigation is negative (either due to ex post market conditions or due to litigation costs). In a simplified model without litigation cost, Avraham and Liu (2012) show that seeking accuracy in the ex post damages assessment leads to over-performance, once one takes into account the breach victim's option to not sue. However, Avraham and Liu (2012) do not account for litigation costs either in terms of attorneys’ fees or costs associated with verifying the victim's actual loss. Litigation cost is characteristically an important factor affecting parties’ decisions of whether to file a suit (see, e.g. Mendell (1983), Png (1987), Polinsky and Rubinfeld (1988), Hughes (1995), Hylton, 1990, Hylton, 2002, and Drahozal and Hylton (2003)).¹⁰ Thus, in this article we introduce positive litigation costs into the model, and ask whether courts should still apply flat ex ante expectation damages instead of ex post actual damages that are adaptive to post-contracting information. As stated above, costly litigation changes the equilibrium, and ex post expectation damages may induce under-performance (in contrast to Avraham and Liu (2012) where ex post damages lead to over-performance). Nonetheless, we show here that even when accounting for verification costs and/or attorneys’ fees, ex ante expectation damages are still typically more efficient than ex post actual damages. Seeking ex post accuracy in determining damages, as court so often do, actually distorts breach incentives.

Interestingly, and in contrast to Avraham and Liu (2012), we are able to derive conditions where ex post expectation damages are superior to ex ante expectation damages. This occurs under the English rule, when renegotiation is costless and litigation costs are sufficiently high relative to the expected trade surplus. Therefore, our recommendation to award fixed ex ante damages is especially strong in the U.S. where the English rule does not typically apply.

One needs to distinguish our results from the well-known case of Hadley v. Baxendale, where the court argued that ex ante expectation damages efficiently motivate disclosure of pre-contractual private information.¹¹ In our model parties to the contract have no private information at the contracting stage. The advantage of ex ante expectation damages over actual damages in our model emerges because ex ante damages have lower informational demand and actual damages distort incentives to breach due to the non-breaching party's option to not file a lawsuit.

Our results have some further implications as well. First, when there is a need to incentivize the non-breaching party to minimize her ex post loss, for example, by seeking another trading partner in a timely fashion, our recommendation strengthens. The reason is simple: by awarding ex ante expectation damages courts avoid diluting the non-breaching party's incentives to minimize her ex post losses. Had the non-breaching party been guaranteed ex post damages, her incentive to “cover” in the market would have not been optimal.¹²

Second, our results provide yet another argument against the penalty doctrine for the liquidated damages, only in conditions unexplored before in the literature. When parties have symmetric incomplete information upon contracting, stipulated damages shall be enforced by courts, no matter whether ex post the damages seem to be over- or under-compensatory.¹³

Third, our results help explain the rationale behind section 2-713 of the U.C.C. which has been widely criticized. Section 2-713 sets a buyer's damages for non-delivery to equal the difference between the market price at the time of delivery and the contract price. But, as many critics have observed, that measure might over-compensate buyers whose real ex post valuation is low.¹⁴ In contrast, we argue that as long as courts always employ the ex ante approach, then section 2-713 is defensible, even though it might sometimes over-compensate buyers.¹⁵

Fourth, our results are relevant to a recent trend among a few legal economists to favor the disgorgement remedy. For example, Richard Brooks has recently argued that disgorgement of the promisor's profits is as efficient a remedy as expectation damages.¹⁶ A 2011 paper by Steve Thel and Peter Siegelman takes it further and argues that requiring the breaching party to not only pay the other party's expectation damages but also to disgorge any additional profits is the preferred contract remedy.¹⁷ This disgorgement theory involves an ex post calculation of damages, which, in the conditions we investigate in our model, will not lead to efficient results.

Fifth, our results imply that section 39 of the proposed Restatement (Third) of Restitution and Unjust Enrichment will create improper incentives for breach.¹⁸ Section 39 would make disgorgement available in circumstances where “a deliberate breach of contract results in profit to the defaulting promisor and the available damage remedy affords inadequate protection to the promisee's contractual entitlement.”¹⁹ This would entail an ex post evaluation of the profit to be disgorged from the breaching party and given to the non-breaching party, which our model shows will not lead to efficient results.²⁰

Our work should be distinguished from previous literature. Ayres and Talley (1995) argue that untailored liability rules induce more credible signaling of private information in price bargaining, and thus facilitate more efficient trade. Scott and Triantis (2006) argue that the equilibrium contract formation depends on the relative informational advantages of contracting parties (at ex ante) versus of the court (at ex post). Our analysis instead focuses on the parties’ endogenous decision of whether to litigate the breach, given costly litigation. In particular, we are assuming that parties have no informational advantage vis-a-vis the court at the contracting stage.

Kaplow (1994) and Kaplow and Shavell (1996) argue that if the decision maker is informed about the harm when making the decision, more accurate ex post damages assessment will improve efficiency. However, if the decision maker does not know the harm when making the decision, more accuracy in damages assessment will not improve efficiency but waste resources in establishing the actual damages, because greater precision ex post in damages assessment “cannot improve the earlier decision” (Kaplow, 1994, p. 314). Our model fits into the uninformed decision-maker scenario in the Kaplow and Shavell model as we assume that the seller does not know the buyer's private valuation when deciding whether to breach the contract. However, our argument against ex post damages is based on a different rationale in such an informational environment: under ex post damages a privately informed victim with low damages may choose not to sue, and this actually pushes up the expected punishment in litigation (recall the missing zero-loss plaintiffs effect and see Fig. 2 in Section 3), thus leading to over-performance. Therefore, in an incomplete contracting context when the decision maker is uninformed, greater precision ex post not only does not improve the ex ante decision as pointed out by Kaplow and Shavell, but actually exacerbates the ex ante decision due to the potential victims’ self-selection in litigation decisions.

Ben-Shahar and Bernstein (2000) find that in repeated transactions an aggrieved party may not file a suit if doing so requires disclosure of private information, thus hurting her future competitive position.²¹ In our one-shot model, an aggrieved party may choose not to sue due to her negative net payoff from litigation regardless of any secrecy interest.

Bowels (2008) recently surveyed the literature on ex ante versus ex post measures of commercial damages, and argued that in an efficient market ex post damages (which he called hindsight) result in overcompensation of the plaintiff. He found hindsight may work for or against the plaintiff, depending on the litigation cost, expected economic profit, and the probability and size of negative outcomes. Bowels correctly pointed out the disallowance of negative damages in contract law²² and its effect on compensation, but he did not formally compare the joint payoff under ex ante versus under ex post damages, from which we derive our main results. Also Bowels did not consider renegotiation.

In our model with renegotiation the seller may strategically breach (breach when performance is profitable) to extract surplus from the buyer through renegotiation. Luelfesmann (2009) illustrates a similar point in a model with investments. A seller may strategically underinvest so as to render ex post trade being inefficient, then he could extract surplus via renegotiation. For simplicity we assume a costless discovery process in litigation. Schwartz and Watson (2004) show that the (endogenous) cost of contracting and renegotiation affects parties’ choice of initial contractual forms (simple versus complex contracts) and relation-specific investments, and therefore the contracting parties exhibit preferences over legal rules and other factors that affect the costs of contracting and renegotiation.

The rest of the paper is organized as follows: In Section 2, we present a simple model of buyer–seller contracting with costly litigation. In Section 3, we compare the efficiency of ex ante versus ex post expectation damages for the case with positive verification costs. Then in Section 4, we account for parties’ general litigation costs. For each remedy we analyze both cases with and without renegotiation, and we also compare the American rule with the English rule of litigation cost shifting for each case. In Section 5, we summarize our results and conclude. Appendix A provides a proof that the buyer's participation constraint in the seller's optimization problem is binding. In Appendix B Equilibrium price and expected joint payoff under actual damages with renegotiation when verification is costly, B.1 Under the American rule, B.2 Under the English rule, Appendix C Equilibrium price and expected joint payoff under actual damages when litigation is costly and there is no renegotiation, C.1 Under the American rule, C.2 Under the English rule, Appendix D Equilibrium prices and joint payoffs under ex ante expectation damages and actual damages when litigation is costly and parties may renegotiate the contract ex post, we provide detailed specifications of equilibrium prices and expected joint payoffs under various regimes.