Academic journal article Stanford Law Review

Reconsidering Contractual Liability and the Incentive to Reveal Information

Academic journal article Stanford Law Review

Reconsidering Contractual Liability and the Incentive to Reveal Information

Article excerpt

In an earlier work, Professors Lucian Arye Bebchuk and Steven Shavell analyzed how the legal rules governing contractual liability affect the transfer of information between the parties to a contract. In particular, they showed how limitations on contractual liability might lead high-valuation buyers to reveal their valuation of performance, and they identified the circumstances under which such limitations on liability are and are not socially desirable. In an article published in this issue of the Stanford Law Review, Professor Barry E. Adler develops a critique of Professors Bebchuk and Shavell's analysis, as well as that of Professors Ian Ayres and Robert Gertner, who independently argued that contractual rules can facilitate transfers of information. Professors Bebchuk and Shavell reconsider here the subject of contractual liability and the revelation of information and respond to Professor Adler's critique. Professors Bebchuk and Shavell find Professor Adler's model to be a natural extension of theirs rather than a departure from it. Their reexamination leads to the conclusion that the informational effects that their work analyzed are important to take into account in designing contract rules.

I. CONTRACTUAL LIABILITY AND THE REVELATION OF INFORMATION

In an earlier article,(1) we analyzed how the rules governing contractual liability--and, in particular, the role developed in the famous case of Hadley v. Baxendale(2)--might spur desirable transfers of information when contracts are formed. We analyzed the nature of the informational advantage that the Hadley rule might possess, and we identified the circumstances under which this rule is and is not desirable.

Ian Ayres and Robert Gertner, working independently of us, also examined how the Hadley rule might provide incentives to transfer information.(3) Unlike our article, theirs did not analyze the possibility that the Hadley rule would be undesirable and did not identify the exact informational advantage of the rule. But, like us, they suggested that the Hadley rule might serve a beneficial role in inducing buyers to reveal information to sellers.

In an interesting article published in this issue of the Stanford Law Review,(4) Barry Adler takes issue with our analysis as well as that of Ayres and Gertner. He argues that we overlooked an important factor that can significantly affect the desirability of the Hadley rule. Furthermore, because the presence of this factor might make it more difficult to identify when the Hadley rule would and would not be desirable, he suggests that lawmakers should treat skeptically the type of considerations on which our work has focused. In this response, we examine whether his criticism of our work is warranted and, ultimately, suggest that it is not.

The case of Hadley, and the rule that it established, are quite familiar to students of contract law. In that case, Hadley, a mill owner, engaged Baxendale, a carrier, to transport a broken engine shaft to another city by a certain date. The value to Hadley of performance was much greater than ordinary because the broken shaft was to serve as a model for a new one without which his mill could not operate. But Hadley did not inform Baxendale of his high valuation of performance. When Baxendale failed to deliver on time and Hadley sued, the court declined to grant Hadley damages equal to the large losses he suffered as a result of the failure to perform.(5) The court established that liability should be limited to losses "arising ... according to the usual course of things," or that "may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it."(6) For Baxendale to be responsible for Hadley's lost profits, the court stated that Hadley had to have communicated his particular circumstances to Baxendale at the time that the contract was made.(7) This limitation on liability for breach of contract to the ordinary, foreseeable level of losses, unless the promisee had informed the promisor otherwise, has become generally accepted in the common law world. …

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