Balancing Grower Protection against Agency Concerns: An Economic Analysis of Contract Termination Damages

Article excerpt

This study examines legislation that would grant growers termination damages if their contracts are terminated. Our model suggests that, with no contracting frictions, damages would not reduce ex ante efficiency as processors can contract around damages through contract restructuring. Growers would earn less under continuation but would be protected if terminated, although overall expected profits would be unaffected. However, when contracting frictions exist, then efficiency losses can occur as processors would be constrained in restructuring contractual incentives to deal with moral hazard. Growers' expected profits would increase while processors' profits would decrease.

Key words: contract law, contract regulation, damages, incentives, principal-agent

Introduction

Many policy makers and farm advocates have alleged that contracts used in agricultural production or procurement are unfairly biased in favor of large food processors at the expense of growers. This debate has created political pressure in some states to enact new laws designed to regulate the contracting process. A model state law titled the Producer Protection Act (PPA) was recently proposed by 16 state attorneys general. The PPA provides a list of regulations designed to protect growers and to provide them with some bargaining power in the event they are involved in contract disputes with large food processors.1 Among these regulations are rules that protect growers from undue termination or nonrenewal of contracts by providing growers with the right to be "... reimbursed for damages incurred due to the termination, cancellation, or failure to renew. Damages shall be based on the value of the remaining useful life of the structures, machinery or equipment involved" (PPA, Section 8).

One rationale for termination damages legislation is that, at the outset of a contract, processors often require farmers to make investments in new production facilities, which can be relationship specific whereby the facilities have little value outside the contract, making it difficult for growers to recapture their investments if they are terminated. For example, specialized broiler and hog housing facilities can have various dimensions of relationship specificity, and sugar beet production may require specialized harvesting equipment, investment in seed beds, etc. [see MacDonald et al. (2004) for an extensive discussion of asset specificity in agriculture] . These investments give contracts a longterm flavor in the sense that it may take several trading rounds (e.g., several seasons, flocks, etc.) before growers can pay off debts incurred from their investments.2 However, many processors do not provide farmers with written guarantees that the contracts will not be terminated before all debts can be paid. For instance, a group of contract farmers in Arkansas were terminated by Tyson when Tyson ended its pork operation in the region (Smith, 2003).3

While many states have proposed or passed contract termination damages legislation, relatively few economic studies of these laws have been undertaken. The purpose of this article is to provide an economic analysis of contract termination damages. Specifically, we seek to develop an understanding of the efficiency and distributional consequences of damages. We emphasize that this study is simply an economic analysis of what would happen if damages legislation were passed. We do not make value judgments about the merits of the law, but instead point out potential consequences of the law using an economic framework.

This article makes a contribution to the small literature on agricultural contract regulation. A paper most closely related to ours is a study by Lewin-Solomons (2000), who also focuses on contract termination. The difference between the two papers is that she examines restrictions on termination whereas we evaluate termination damages. Our conclusions also differ. Lewin-Solomons finds that a reduction in the probability of termination is generally distortionary and creates unintended consequences which can actually harm growers. …