A Revised Economic Theory of Disclosure Duties and Break-Up Fees in Contract Law

By Grosskopf, Ofer; Medina, Barak | Stanford Journal of Law, Business & Finance, Fall 2007 | Go to article overview

A Revised Economic Theory of Disclosure Duties and Break-Up Fees in Contract Law


Grosskopf, Ofer, Medina, Barak, Stanford Journal of Law, Business & Finance


Introduction

Negotiating parties are usually incompletely informed about elements of the transaction, such as the value of the relevant asset or the costs of performance. A party can negotiate on the basis of what she already knows-e.g., the average value of similar assets-but she can also invest resources in acquiring more information. Often, such investment is socially desirable, since it enables efficient allocation of resources. The investment may be essential not only when neither of the negotiating parties possesses the relevant information, as, for example, in the case of a land that may or may not be oil-rich. Acquiring the relevant information may also be required in the more common case in which one of the parties, typically the seller, already possesses the relevant information but cannot credibly convey it to the other party. In the latter type of cases the information gathering may be required to prevent a process of "adverse selection" that forms an inefficient outcome of "market for lemons."

Seemingly, a negotiating party will invest resources in information gathering only if she expects to control the flow of information that her efforts generates or if she is guaranteed to receive reimbursement for the investment if the negotiations fail. For instance, assume that a contractor negotiates with a potential customer for the supply of some product or service. The contractor can either submit a price offer that is based on the average costs of this type of work or invest resources in discovering the actual costs of the potential project. Arguably, the contractor will be motivated to gather information before submitting her offer only if she expects that the information will not be revealed to the customer. Under this condition, the contractor can extract a profit by using the information to charge more for high-cost projects, while still pricing low-cost projects according to the average costs of this type of work. In contrast, if the acquired information is revealed to the customer, a customer whose project requires low-cost may be able to use it to his advantage by demanding price reductions. Consequently, the contract price will reflect the actual cost of performance and the contractor will not be able to cover her pre-contractual (and thus "sunk") investment in acquiring the information. Thus, the prevailing premise is that contract law should protect the investing party's ability to benefit from its investment by exempting it from the duty to disclose "deliberately acquired information" to its counterpart.1 In addition, in some cases the privilege not-to-disclose does not provide sufficient incentives to collect information. This is the case, for instance, when the other party knows about the investment in acquiring information and can infer from the investing party's behavior what facts the latter has discovered. It was argued that in such cases the investing party should be ensured to be reimbursed of her pre-contractual expenditure if the negotiations fail, through termination or break-up fees.2

However, a closer look reveals that these arguments disregard an important possible motivation to invest. A contracting party may invest resources in acquiring information not only -and often not even primarily-to gain informational advantage over her counterpart, but to achieve an advantage vis-à-vis its competitors. In the above example, assume that the contractor, who negotiates with a potential customer for the supply of some service, acts in a competitive environment, such that her likelihood of winning the contract increases the lower her price offer is. Given the competition, the contractor may well have an interest in investing in acquiring information about the actual costs of performance, even if the contractual price is expected to resemble the actual costs of performance. The acquired information will enable the contractor to submit lower price offers to customers that require lower than average costs of performance and to increase her market share and profits. …

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