University of Virginia Law School

Transcription

1 University of Virginia Law School The John M. Olin Program in Law and Economics Working Paper Series Year 2008 Paper 46 The Fault that Lies within Our Contract Law George M. Cohen University of Virginia School of Law, This working paper is hosted by The Berkeley Electronic Press (bepress) and may not be commercially reproduced without the permission of the copyright holder. Copyright c 2008 by the author.

2 The Fault that Lies within Our Contract Law George M. Cohen Abstract Scholars and courts typically describe and defend American contract law as a system of strict liability, or liability without fault. Strict liability generally means that the reason for nonperformance does not matter in determining whether a contracting party breached. Strict liability also permeates the doctrines of contract damages, under which the reason for the breach does not matter in determining the measure of damages, and the doctrines of contract formation, under which the reason for failing to contract does not matter. In this essay, prepared for a symposium on Fault and Contract Law sponsored by the University of Michigan School of Law and to be published in the University of Michigan Law Review, I take issue with the strict liability paradigm, as I have in my prior work on contract law. In my view, the theoretical justifications for strict liability as a general paradigm for contract law oversimplify contractual intent, the relationship between intent and fault, and the nature of contractual fault. Moreover, the strict liability label is descriptively misleading, once one dips even slightly below the surface of contract doctrine. Fault shows up throughout contract law. Efforts to make contract law conform more to the strict liability paradigm and exorcise fault are wrongheaded. In any case, such efforts are doomed to fail. Fault may not be the dominant feature of contract law, but it plays an inherent, invaluable, and ineluctable supporting part. The strict liability impulse occurs when contract intent, contract terms, and contract doctrine coincide with a persuasive story of promisor fault, and when the consequences of strict liability are blunted because the promisor can easily mitigate them. But strict liability, like other contract rules, is merely a fault-based presumption. Determining the limits of that presumption means considering why parties make contract and why they do not perform them, in other words, fault. Courts and scholars should would do better to acknowledge the role of fault and think about how to use fault more effectively within the framework of contract doctrine.

3 DRAFT 5/28/08 The Fault that Lies within Our Contract Law George M. Cohen * Scholars and courts typically describe and defend American contract law as a system of strict liability, or liability without fault. 1 I disagree with that position. 2 In my view, the theoretical justifications for strict liability as a general paradigm for contract law oversimplify contractual intent, the relationship between intent and fault, and the nature of contractual fault. Moreover, the strict liability label is descriptively misleading, once one dips even slightly below the surface of contract doctrine. Efforts to make contract law conform more to the strict liability paradigm and exorcize fault are wrongheaded. In any case, such efforts are doomed to fail. Fault may not be the dominant feature of contract law, but it plays an inherent, invaluable, and ineluctable supporting part. Courts and scholars would do better to acknowledge this role and think about how to use fault more effectively within the framework of contract doctrine. The Meaning of Strict Liability in Contract Law Usually when courts or scholars label contract law a strict liability system, they are referring to a specific doctrinal area: performance and breach. Under the strict liability view, a court imposes liability on a contracting party when that party fails to honor his agreement, regardless of whether the court can attribute that failure to any Afault@ by the breaching party. 3 In the paradigmatic case, if a contracting party promises to provide a good or service and fails to deliver, or delivers a defective good or service, that party breaches the contract even if there were no reasonable precautions that party could have taken to prevent the nondelivery or defect. Strict liability means that the contract provides a Awarranty@ of results; it protects against all risk Hosted by The Berkeley Electronic Press

4 of nonperformance or imperfect performance. In short, the reason for nonperformance does not matter. Although the strict liability paradigm appears most prominently in performance and breach doctrine, the paradigm permeates most other doctrinal areas of contract law as well. Broadly speaking, the main doctrinal areas other than performance are formation and remedy. In the contract law of damages, Holmes long ago articulated the strict liability view, which holds that just as the reason for nonperformance does not matter in determining breach, the reason for the breach does not matter in determining contract damages. 4 An aggrieved party who can prove breach is entitled to a remedy that compensates him for his loss, generally defined doctrinally as protecting the expectation interest. Fault seems irrelevant to determining compensation. The strict liability label does not usually appear in connection with the law of contract formation, but formation doctrine also seems to comport with the strict liability view. In this case, however, it is the reason for failing to contract, rather than for failing to perform, that does not matter. Technically, the doctrine is one of strict nonliability rather than strict liability. The idea is the same, though the story is different. Contracts are voluntary agreements; no one is obliged to agree. So contract law generally imposes no liability unless and until the parties agree. However a court might determine whether and when parties agree, Afault@ again seems irrelevant. Justifications for Strict Liability Pronouncing contract law to be a strict liability system is, it turns out, easier than justifying such a system. Two broad types of justifications are a traditionalist or philosophical

5 approach, which focuses on faithfulness to contractual intent, and an economic or functionalist approach, which focuses on the facilitation of better contracting behavior. From a traditionalist perspective, strict liability seems to follow naturally from two simple premises. First, contract law grounds liability in the mutual intentions of the contracting parties. Second, fault is a social judgment distinct from the intentions of the parties. The tort law of accidents between strangers naturally bases liability on fault because strangers have no mutual intentions. Courts in tort cases must therefore resort to some social judgment such as fault. In contract law, by contrast, the parties themselves define the basis and scope of liability, so in theory no social judgment is necessary (other than the social judgment to enforce agreements according to the intentions of the parties). The parties themselves define the standard of conduct applicable to them by the terms of their agreement. 5 The only relevant fault is breach of any agreement the parties intended to make. Fault thus merges with mutual intent and cannot serve as an independent criterion of liability. This justification is incomplete, however. If the parties intend that courts should determine contract liability based on why nonperformance occurred, few people would call that a strict liability system. Strict liability connotes not merely court deference to rules of conduct established by contracting parties, but also a standard of conduct that is not itself fault-based. A traditionalist justification of strict liability, then, must defend the proposition that the parties intend that the reason for nonperformance does not matter. 6 That proposition is, however, often contestable. Law and economics scholars have tried to explain and justify strict liability in contract law on consequentialist grounds. Like traditional scholars and courts, economic scholars start Hosted by The Berkeley Electronic Press

6 from the premise that courts should enforce agreements according to the parties= mutual intention, but proceed differently from that premise. As the well-known theory goes, contracting parties generally have the incentive to form and write efficient contracts, but not necessarily to perform them, so courts facilitate efficient contracting by enforcing the bargain according to the intentions of the parties. If courts try instead to the parties= behavior, for example, by injecting courts= Aown of that conflict with the parties= preferences, parties will contract around those restrictions if they can and lose out on mutually beneficial trades if they cannot. That still leaves the question of whether the parties intend strict liability. Most contracting parties, economists argue, prefer a strict liability contract regime even if they do not expressly say so. The reasons supporting that conclusion usually fall into one of three categories: superior risk bearing, comparative institutional competence, and litigation costs. First, the promisor is usually in a better position than the promisee to bear a risk that would make performance of that promise more costly or less valuable. Institutionally, contracting parties are better equipped than the courts to make whatever fault determinations are desirable. Finally, fault-based liability imposes higher litigation costs on the parties than strict liability, because fault is more costly for courts to assess, and these costs generally outweigh whatever the benefits of a fault-based system. Although these rationales for strict liability have some plausibility and doctrinal support, ultimately they are not persuasive. The Uncertainty of Mutual Intent Both the traditional and economic justifications for strict liability rely on a strong

7 dichotomy between mutual intent and fault. In the traditional view, contract law is about mutual intent and fault is about social judgment. In the economic view, parties fully express their preferences in their contract, so court attempts to impose external fault standards on them will lead to inefficiency. The asserted dichotomy between intent and fault is false, or at least misleading. The relationship between the two is more complex. In the first place, both justifications depend crucially on there being such a thing as the actual mutual intention of contracting parties, which resolves all potential disputes, and which courts can determine with reasonable accuracy at relatively low cost. Otherwise, courts inevitably wind up making illegitimate social judgments or thwarting the preferences of the contracting parties, leading to inefficient contracting around or failures to contract. Determining mutual intent is an inherently uncertain enterprise, however. The very concept of mutual intent is essentially an ideal, like a Platonic form. The parties do their best to express their mutual intent, most commonly in a written contract, but these expressions are imperfect. Contracts are largely a set of rules, and all rules require interpretation, stories that explain their purpose or meaning in a particular situation. 7 As new and unanticipated situations arise, disputes requiring interpretation inevitably occur. Parties generally resolve these disputes on their own, sometimes by modifying their contract, but in some situations they cannot and so bring their disputes to the courts. In these disputes, the parties typically present contesting versions of what mutual intent requires. Contract law helps courts chose between these competing versions of mutual intent. It is designed, therefore, for the marginal case, not the average contract. Contract law is, however, just another set of rules. These rules provide proxies, presumptions, and guidance for how courts should determine mutual intent, but they are also imperfect. Like contract terms, contract doctrines require interpretation. Contracting Hosted by The Berkeley Electronic Press

8 parties engage in such interpretation when they draft, perform, and dispute new contracts, which lead to new court interpretations of contracts and contract law, and the process goes on. The nature of this ongoing process of interpretation belies a fixed and easily determined mutual intent in contested cases. Of course, contracting parties often try to influence court interpretation by expressing in their contract preferences about how courts should ascertain mutual intent. The typical example is merger clauses. We might call this intent procedural or secondary, compared to the substantive or primary intent of how parties should and should not behave under the contract. Defenders of strict liability assert that even if primary intent is uncertain, so long as courts follow the parties= secondary intent, they will generally get primary intent right. 8 That approach, however, merely shifts the problem of uncertain intent to a different place. It does not pre-empt the need for interpretation. In fact, it adds an additional interpretive question: when primary and secondary intent conflict, which should the court follow? 9 The difference between primary and secondary intent is just one example of a more general phenomenon: multiple intents. Contracting parties may have more than one goal. They may make multiple promises and incur multiple obligations. Multifaceted intent compounds the problem of uncertainty and further muddies the distinction between intent and social policy. The more expressions of intent there are, the more likely it will be that disputes will arise over how to reconcile or prioritize the different intentions when they conflict. I do not mean to suggest that the uncertainty of intent and the need for interpretation mean that all interpretations of intent are equally valid. Quite the opposite. Some interpretations are better than others. Rather, my point is that the justifications for strict liability assume that

9 expressing and determining intent is relatively easy and writing down more or better contract terms or contract doctrine can obviate or minimize the need for interpretation. Otherwise, how would one know when courts are lapsing into illegitimate Asocial policy or creating A inefficient@ rules. We should be wary of overly confident assertions of mutual intent without sufficient justification or acknowledgment of plausible alternative interpretations. Otherwise, a theory that supposedly fosters judicial humility winds up instead fostering judicial hubris. In my view, true humility lies in acknowledging the uncertainty of intent. Doing so opens the door to fault. The Relationship Between Fault and Intent The strong dichotomy between intent and fault, on which the justifications for strict liability depend, founders not only on the uncertainty of intent, but also the variety of ways that fault can help inform intent. First, contracting parties can expressly use fault concepts in their contracts. Examples of contract terms incorporating a fault standard include best efforts, 10 good faith, and reasonableness clauses. When disputing parties call on courts to interpret these terms in determining mutual intent, fault gets incorporated into contract law. Second, parties may intend to be governed by fault standards even if they do not expressly say so. Courts that perceive such intent will imply fault standards as part of the contract. The most common example is a contract for professional services, for which courts presume that the professional does not intend to guarantee results, and the client agrees to accept the professional standard of care. Although less frequently mentioned, courts often apply similar standards to other service contracts. 11 Moreover, in agency and other fiduciary contracts, courts imply duties of care and loyalty because they presume principals and agents intend that agents Hosted by The Berkeley Electronic Press

10 should not misbehave by shirking or pursuing conflicting interests or the like. Third, contracting parties often draft terms designed to discourage certain kinds of conduct. Even though these terms do not explicitly mention fault, fault may help explain the purpose behind these terms and therefore facilitate their interpretation. For example, progress payments reduce the ability of the paying party to hold up a performing party who goes first. Contingency payments encourage effort that might not otherwise be forthcoming. These terms often present questions of interpretation, not only of these terms themselves but of how they relate to the contract as a whole. On the one hand, the terms reveal the parties= concern with fault, which a court may interpret as extending beyond the domain of the specific term. On the other hand, courts may interpret these terms as expressing the parties= intent that the terms are the exclusive means of addressing fault. That is, the terms represent an attempt to pre-empt court determinations of fault. If the former interpretation is at least in some cases better, as I believe it is, fault will be relevant in determining mutual intent. Fourth, fault can help resolve a conflict between plausible competing interpretations of intent by focusing on narrower grounds. Courts may be more confident about whether the parties intended to prohibit specific conduct in a particular circumstance than about what the parties affirmatively intended, or intended more generally in their contract. 12 Finally, fault may be inconsistent with contractual intent. Contract terms may expressly or impliedly attempt to limit the application of fault. For example, courts interpret insurance contracts as expressing the intent that the insurance company=s fault in assessing risk is irrelevant; if a risk that the policy covers occurs, the insurance company must pay. Similarly, courts interpret the intent of option contracts 13 and at will employment contracts as generally

11 giving absolute discretion to one or both parties, thereby making fault irrelevant. The previous discussion, however, suggests several caveats against too quickly assuming inconsistency between intent and fault, as critics of fault doctrines like good faith sometimes do. Sometimes what appears to be a conflict between fault and intent may in reality reflect different interpretations of uncertain intent. 14 Moreover, terms limiting fault require interpretation about how for these limits extend. Fault may reappear if the reason for excluding fault does not apply. Lastly, I know of no evidence or theory to support the proposition that contracting parties ever intend the exclusion of all considerations of fault in all aspects of their dealings. We do not see contracts, for example, in which parties agree to flip a coin to resolve any possible dispute that might arise. The Meaning of Fault in Contract Law Having discussed the strict liability theory=s unsatisfactory dichotomy between intent and fault, I turn now to the economic theory of superior risk bearing and the question of whether it supports strict liability. Ironically, the superior risk bearer idea, which is itself fault-based, has led to an unduly cramped view of the role of fault in contract law. One reason for this is an excessive focus on precaution-taking. From the perspective of precaution-taking, strict liability (or strict nonliability) makes sense in four cases: (1) cost-effective precautions are generally possible, and the defendant is so often the better precaution-taker that the benefits of making individualized fault assessments are not worth the costs; (2) fault is likely to be equally balanced on both sides, so making relative fault assessments is not worth the cost; (3) the activity itself should be discouraged rather than done safely; and (4) neither party can take cost-effective precautions against some risk. Hosted by The Berkeley Electronic Press

12 Contract law contains examples of each of these cases, though each has its limits. For example, case (1) seems to describe the paradigm strict liability case of a failure by the seller of goods or services to take reasonable precautions, such as proper quality control, as a result of which the goods or services are defective. We have already seen, however, that courts abandon strict liability in the case of services when the assumptions underlying strict liability do not hold. Case (2) seems to describe the situation in which both parties are equally able to take precautions by adding contract terms that protect their interests or clarify their intent, so in cases of ambiguity either one could be deemed at fault and liability should not turn on the failure to take such precautions. A notable exception to this rule is, of course, the rule of interpreting ambiguities against the drafter when one party drafts the contract. 15 Case (3) includes the consideration doctrine=s refusal to enforce gratuitous promises, because enforcing such promises might discourage parties from making them. There are exceptions to this doctrine, however, in cases in which the concerns with activity level effects are reduced. 16 Case (4) includes changes in market conditions that neither party could take precautions to prevent. Even here, contract law can encourage a different kind of precaution taking, such as precautions to reduce the harm that does occur. The foreseeability doctrine in contract damages serves this purpose. In fact, however, the nature of contractual liability provides space for a much more robust notion of fault. 17 Although precaution-taking is important in contract law, two other forms of fault B mitigation and opportunism B are even more important. Precaution-taking matters in two situations where contract law most resembles the tort law of accidents: accidental contracts and accidental contingencies. 18 Accidental contracts are contracts that should not have been made, that is they were jointly unprofitable at the time of formation, but one or both parties did not

13 know that. Accidental contingencies are circumstances arising after contract formation that make the contract jointly unprofitable. In both cases, it makes sense to ask whether the contracting parties could have taken reasonable precautions to prevent the contract or the contingency, for example by investing more in information. On the other hand, if the contract is jointly profitable when made and continues to be jointly profitable, but a Aregret contingency@ occurs that makes the contract less profitable for one side, then mitigation and opportunism become more important. 19 Although contract doctrine focuses on promisee mitigation, promisors can mitigate as well; in fact, the often superior ability of promisors to mitigate is a crucial, though often underappreciated, rationale for strict liability in contract performance and contract damages, and to some extent strict nonliability in contract formation. A key feature of mitigation is the ability to provide substitute performance, and promisors are often in a better position than promisees to repair and replace their defective performance or purchase market substitutes. By the same token, promisees are often better able to Amitigate@ by finding substitute contracting partners at the formation stage. Contracting parties cannot mitigate or take reasonable precautions to prevent all contractual losses, however. That is where opportunism comes in. One party in a contractual relationship often takes some action, or fails to take some action, that creates the possibility of non-mitigatable loss; that is, one party becomes vulnerable to wrongful expropriation by the other, with Awrongful@ defined with reference either to the parties= agreement, contractual norms, or conventional morality. In the paradigmatic case of opportunistic behavior, one party makes a relationship-specific investment (or Areliance expenditure@ in legal terms) in the contract, which leaves that party vulnerable to threats by the other to deprive the first party of his investment. Specific investments can occur before or after the formation of the contract. A party may form Hosted by The Berkeley Electronic Press

14 an intention to act opportunistically not only at the outset of a contractual relationship (classic A fraud@) but as the relationship proceeds. More important, opportunistic behavior can occur even in the absence of specific investments. All that opportunism requires is some change in position growing out of the contractual relationship that exposes one party to potential and non-mitigatable risk or loss that intentional conduct by the other party can impose. This vulnerability can arise in a number of ways. For example, one party may perform before the other one does, providing a benefit to the other party who may then try to keep that benefit without performing his reciprocal obligations. Or one party may forego other contracting opportunities, which then become unavailable, such as when market prices or other market conditions change. Or one party may make information available to the other party, who may then use the information to the first party=s disadvantage. Or one party may act negligently and the other party, aware of the first party=s negligence, tries to exploit rather than correct it. 20 Many contract terms and contract law doctrines aim to deter opportunistic behavior. Identifying opportunistic behavior is not always easy, however. One problem is that all contract rules and contract law doctrines themselves create the potential for exploitation by a party seeking to act opportunistically. Contrary to the views of some scholars, 21 the potential for making opportunistic use of contract terms and contract law doctrines is not limited to the kinds of legal precepts often referred to as Astandards@; as I argued above, all legal precepts require interpretation, no matter how they are formulated. Not only may a party seeking to act opportunistically attempt to justify its behavior under some contract term or contract law doctrine, such a party may also try to justify its behavior by pointing to its own (real or asserted)

15 non-mitigatable loss. Contract disputes, then, present questions not only about precaution-taking, but whether the problem causing nonperformance was accidental, whether and by whom any losses at any stage could be mitigated, and whether either party is acting opportunistically. In short, there are good reasons for thinking that the reason for nonperformance often matters in litigated cases. Despite the claims of strict liability theorists to the contrary, contract doctrine often allows parties to make such arguments. The Appearance of Fault in Contract Doctrine The concept of fault appears throughout contract doctrine, but in ways that seem to defy any coherent pattern. Fault is like an odd relative that contract doctrine for the most part tries to hide in a closet, but somehow refuses to be cabined and keeps peskily poking its head out. A theory that seeks to explain contract law must attempt to understand how and why fault appears in contract doctrine. Just as contracts may expressly include fault concepts, so contract doctrine contains a number of direct expressions of fault. The bewildering variety of these expressions scattered throughout the doctrinal landscape of contract law obscures the ubiquity of fault concepts. Fault expressions in contract doctrine include: fault, good faith, best efforts, unconscionability, wilful breach, injustice, forfeiture, know or has reason to know, all the circumstances, and reasonable diligence. Even when contract doctrine does not use fault language, the doctrine=s purpose may be to discourage certain types of faulty behavior. For example, the statute of frauds, parol evidence rule, the objective theory of contracts, and to some extent the consideration doctrine aim to deter Hosted by The Berkeley Electronic Press

16 assertions of false promises. Moreover, contract doctrines often contain fault-based presumptions. One may find such presumptions even in doctrines not obviously directed at fault. For example, one can understand the market damage rule as reflecting a fault-based presumption that breaches to take advantage of a change in market price are opportunistic. The concept of fault-based presumptions is important because fault becomes relevant if the assumptions underlying the presumptions do not hold. Fault can also serve as a check on contract doctrines when courts fear that these doctrines may otherwise lead them to stray too far from intent. Fault in this case is the metric by which courts assess the gap between formalist concepts and normative reality. Similarly, courts sometimes turn to fault when they must make choices between which doctrinal category to use when several are available in a particular case, navigate between doctrines and their exceptions, and help resolve conflicts between doctrines. With these roles for fault in contract doctrine in mind, I offer some representative examples of where fault concepts appear in contract doctrine. Because I have previously written about fault in contract damage doctrine, I will focus on other areas. The term Afault@ appears infrequently in the Restatement and UCC Article 2. Most occurrences of the term are connected to the excuse doctrines of mistake and impracticability. That is surprising. The usual justifications for the excuse doctrines emphasize the mutual innocence of the parties, not fault. 22 Yet the excuse doctrines include provisions that limit their application if the party asserting the defense is Aat fault.@ 23 The excuse doctrines are based on inadequate information available to the parties at the time they contracted. In mistake, the information relates to facts; in impracticability, it relates to

17 risks. If the parties, had they known the relevant facts, would not have contracted or, had they known the relevant risk, would not have required the party disadvantaged by the risk under the contract to bear it, the parties most likely would not have wanted the contract enforced. A party seeking enforcement in this situation is likely acting opportunistically. Contract law responds by shifting the presumption from strict liability to strict nonliability. Determining the parties= mutual intent about what relevant facts or risks they assumed when contracting is, however, uncertain. As a result, rules allowing excuse for mistake or impracticability give promisors a vehicle for claiming these excuses opportunistically, that is, by falsely alleging a Amistake@ or A impracticability.@ Excuse doctrine tries to reduce the risk of promisor opportunism that it introduces. First, the doctrine requires the promisor to present some kind of Aobjective@ evidence, meaning not easily subject to promisor manipulation. In the case of mutual mistake, the objective evidence is that the other party is also mistaken; in impracticability, the change is usually either a market change, or a change specific to the promisor that is hard to fake, such as death or destruction of a particular thing. In either case, the doctrine also allows evidence relevant to determining which party is the superior mitigator. Finally, the doctrine allows the promisee to challenge the application of the doctrine by proving Afault@ by the promisor. My concern is not to defend particular details or interpretations of excuse doctrine. Rather, my point is that the existence and structure of excuse doctrine are neither accidental nor aberrational. It establishes a pattern repeated throughout contract doctrine. The doctrine itself aims to deter opportunistic behavior by one party, but in doing so creates the possibility of opportunistic behavior by the other party, and so contains an exception or limitation to deal with this possibility. Regardless of the limited use of the term Afault,@ the doctrine as a whole Hosted by The Berkeley Electronic Press

18 contains both fault-based presumptions, and in addition some doctrinal vehicle by which the parties can introduce and contest fault assessments. These fault assessments are bounded. The doctrine tries to rely on objective evidence, such as the knowledge or conduct of both parties, the knowledge or conduct of third parties (the or the and whether one party can more easily get substitutes. Consider another pair of doctrinal examples that, like mistake and impracticability, straddle the domains of formation and performance. The doctrines of misunderstanding in R2d ' 20 and interpretation in R2d ' 201 are essentially identical, and both incorporate a fault standard, though without using the term Afault.@ 24 Instead, both sections use the concepts of Aknow@ and A reason to know,@ fault concepts that appear in the law of fraud. Like mistake and impracticability, the misunderstanding and interpretation rules seem to start from the premise that fault does not matter. If the parties agree on a meaning, that meaning prevails. If they A attach different meanings@ to Amanifestations of assent,@ a Apromise,@ an Aagreement,@ or Aterms,@ there is no contract so long as neither party is at fault or both are equally at fault. If, however, the relative fault of one party exceeds that of the other, there is a contract and meaning of the party whose fault is greater loses. 25 A party who knows or has reason to know the other party=s meaning is likely acting opportunistically in asserting a contrary meaning. The Aknow or has reason to know@ standard opens the door to fault assessments. One might well ask how sections 20 and 201 square with the objective theory of contract. The objective theory is based on manifestations that have Aobjective@ meanings. The Aattached meanings@ of sections 20 and 201 seem subjective rather than objective. In fact, however, sections 20 and 201 are perfectly consistent with the objective theory of contract if that theory is

19 understood in fault terms. The objective theory presumes that when one party manifests intent, and later asserts a different intent, either he negligently misled the other party or is acting opportunistically now. That is, the party manifesting intent Aknows or has reason to know that the other party may infer from his conduct that he assents.@ 26 Sections 20 and 201 say precisely the same thing. If, on the other hand, the fault-based presumptions of the objective theory do not apply, the grounds for applying the objective theory disappear as well. 27 The Aknow or has reason to know@ standard calls attention to the opportunistic use of information, 28 a subject that has received insufficient attention from the defenders of strict liability. For example, knowledge plays a prominent role in the law of agency, which significantly overlaps with contract law. Agents make most business contracts. Agency law contains a doctrine that imputes to the principal knowledge of facts that the agent knows or has reason to know. 29 But how this doctrine relates to contract law is not always clear. 30 In particular, many contract disputes arise when the company=s agents who negotiated the contract are not the same as the agents seeking to enforce or escape it later. 31 When, for example, management changes, is the new management bound by the understandings of the old management under the imputation of knowledge doctrine? The imputed knowledge doctrine is itself based on fault considerations, namely the need to balance the danger of the agent withholding bad information from the principal to the disadvantage of the third party against the danger of the agent colluding with the third party against the interests of the principal. Thus, deciding how it ought to apply in contract law inevitably invites fault assessments. The Aknow or has reason to know@ standard also appears in a number of formation rules governing offer and acceptance. Offer and acceptance doctrine may seem largely removed from Hosted by The Berkeley Electronic Press

20 fault. As mentioned already, freedom not to contract seems to limit the role of fault in contract formation. Further support for fault-free formation doctrine comes from the fact that the duty of good faith does not apply to contract formation. In fact, this is an artifact of focusing on only one aspect of information. Contract law excludes the duty of good faith from formation to allow parties to misrepresent certain information about themselves for the purpose of protecting their private information and their investment in that information, and thereby obtaining a larger share of the contractual surplus. Once again, however, a rule that seems designed to preclude fault considerations instead merely defines the boundaries of such considerations. There are other ways that parties can opportunistically abuse information in the contract formation process. For example, one party cannot mislead the other about the likelihood of a deal to obtain more time to evaluate the deal. A party who wants more time must either take a chance that the other will walk away or buy an option. By the same token, a contracting party cannot opportunistically forestall the other party=s ability to acquire further information necessary to evaluate the deal by insisting on the deal=s closure when the first party has reason to know the other party is still investigating. 32 Nor can a party use negotiations to extract and then expropriate beneficial information from the other party without paying for it. A final example is the use of the word Ajustice@ in connection with formation doctrines based on reliance. 33 These doctrines developed to thwart what courts perceived to be opportunistic attempts by promisors to escape liability through various strict nonliability rules of formation: consideration, offer and acceptance, and the statute of frauds. As we have seen, reliance can provide a platform for opportunistic behavior by those seeking to rely on strict

21 interpretations of rules. But as is well understood, reliance is not by itself proof of opportunistic behavior. And reliance-based liability itself can lead to opportunistic investments in or assertions of reliance. So once again, contract doctrine provides an outlet for making fault assessments, by limiting the application of reliance doctrines to situations in which requires enforcement. The Inevitability of Fault Even if one disagrees with my conclusions that fault often comports with mutual intent and believes that contract doctrine should be revised to reduce further or eliminate entirely the role of fault in contract law, I believe there is an additional problem with rigorous and systematic strict liability regime: it cannot work. Law is an inherently normative enterprise and judges are part of that enterprise. They are not automatons; they exercise judgment, which includes making normative assessments like fault. Coase taught us that contracting parties can often contract around unwanted legal rules. But we sometimes forget the legal realist lesson (perhaps we should call it the Court Theorem) that courts can often find ways to exercise fault judgments if they are inclined to do so, through interpretation of contract terms, contract doctrine, or other legal doctrines outside of contract. Game theorists fail to capture this phenomenon because they model courts as setting the rules the parties play by and then largely disappearing from the scene. In reality, courts are players in an ongoing and constantly changing game. There will of course be differences in inclinations toward strict liability or fault approaches, not only across judges but for individual judges across cases. The point is, however, that fault will out. Conclusion: A Role for Strict Liability, and Fault Although I have argued that the strict liability view of contract law needs to be Hosted by The Berkeley Electronic Press

22 significantly qualified, it is important to recognize the source of the strict liability impulse. Strict liability matters when contractual intent, contract term, and contract doctrine coincide with a persuasive story of promisor fault. Moreover, strict liability makes the most sense when its consequences are blunted, most notably because the promisor can easily mitigate by getting substitutes. The conditions for strict liability are most likely to exist in contracts for the sale of goods. We are comfortable interpreting these contracts as allocating the risk of changes in market price, or requiring perfect tender, in large part because of the assumption of easy substitutability. These situations are certainly not trivial in contract law. Nevertheless, they are far from describing the full spectrum of contract disputes. Even in goods cases, the conditions for strict liability are often not satisfied. In those situations, we should expect to see, and do see, courts incorporating fault standards into their considerations of contract liability, as we do in many services contracts. In short, strict liability encompasses situations in which courts feel comfortable presuming promisor opportunism. Calling contract law a strict liability system serves the useful purpose of emphasizing contract law=s commitment to deterring promisor opportunism. But strict liability, like other contract rules, is merely a fault-based presumption. Determining the limits of that presumption means considering why parties make contracts why they do not perform them, in other words, fault. Scholars should embrace and help shape the fault that lies within our contract law, rather * Brokaw Professor of Corporate Law, University of Virginia School of Law. 1 See, e.g., R2d Chapter 11, Introductory Note (AContract liability is strict liability.... The obligor is therefore liable in damages for breach of contract even if he is without fault....@); Bruce W. Frier & James J. White, The Modern Law of Contracts 23 (2005).

23 2 This essay thus continues a theme that has run throughout my writing on contract law. George M. Cohen, The Negligence-Opportunism Tradeoff in Contract Law, 20 Hofstra L. Rev. 941 (1992); George M. Cohen, The Fault Lines in Contract Damages, 80 Va. L. Rev (1994); George M. Cohen, Implied Terms and Interpretation in Contract Law, in 3 Encyclopedia of Law and Economics 78 (Boudewijn Bouckert & Gerrit de Geest, eds., 2000); George M. Cohen, Finding Fault with Wonnell=s ATwo Contractual Wrongs,@ 38 San Diego L. Rev. 137 (2001). 3 R2d ' 235 cmt. b (AWhen performance is due,... anything short of full performance is a breach, even if the party who does not fully perform was not at fault....@). 4 Globe Refining Co. v. Landa Cotton Oil Co., 190 U.S. 540, 544 (1903) (AIf a contract is broken the measure of damages generally is the same, whatever the cause of the breach.@). For a critique of the Holmesian strict liability view of contract damages, see Cohen, Fault Lines, supra note 2 5 The traditionalist justification is one possible interpretation of Holmes= famous statement: AThe duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it, B and nothing else.@ Holmes, The Path of the Law, 10 Harv. L. Rev. 457 (1897). 6 Professor Smith defends a much more sophisticated philosophical approach to strict liability. He accepts that contracting parties intend to compensate each other regardless of the reason for nonperformance. He then divides the contractual obligation into an obligation to perform and then a separate obligation to pay compensation in the event of innocent nonperformance. He then argues that courts apply a Afault@ system of liability to each obligation, which ends up looking like a system of strict liability because any Afault@ assessment by a court winds up being irrelevant. Stephen A. Smith, Contract Theory (2004). 7 See generally Robert Cover, The Supreme Court, 1982 Term B Forward: Nomos and Narrative, 97 Harv. L. Rev. 4 (1983). (2003). 8 Alan Schwartz & Robert E. Scott, Contract Theory and the Limits of Contract Law, 113 Yale L.J I have a similar reaction to recent theories that argue for less judicial intervention in contracts on the ground that parties intend to rely on Afairness norms@ rather than court enforcement. See, e.g., Robert E. Scott, A Theory of Hosted by The Berkeley Electronic Press

24 Self-Enforcing Indefinite Agreements, 103 Colum. L. Rev (2003). Suppose that parties do have that intention (which is far from clear in many cases). If one party behaves unreasonably, and so violates a fairness norm, the other party may, in violation of another fairness norm, take the dispute to court. The theorists argue that the procedural norm should take priority over the substantive norm. Why? Violating either norm will make some people more reluctant to rely on fairness norms. 10 See generally, E. Allan Farnsworth, On Trying to Keep One=s Promises: The Duty of Best Efforts in Contract Law, 46 U. Pitt. L. Rev. 1 (1984). 11 For example, in Milau Assocs. v. North Ave. Development Corp., 368 N.E.2d 1247 (NY 1977), the court rejected the application of UCC ' (implied warranty of fitness for a particular purpose) to a contract for the installation of a sprinkler system in a building, finding instead that Aunless the parties have contractually bound themselves to a higher standard of performance, reasonable care and competence owed generally by practitioners in the particular trade or profession defines the limits of an injured party=s justifiable demands.@ Id. at The court added: AGiven the predominantly service-oriented character of the transaction, neither the code nor the common law of this State can be read to imply an undertaking to guard against economic loss stemming from the nonnegligent performance by a construction firm which has not contractually bound itself to provide perfect results....@ Id. at See also R2d Agency ' 377 cmt. b (reasonable efforts standard applies to agency contracts); UCC ' 2-306(2) (implying Abest efforts@ obligation in exclusive dealing contracts involving goods unless the parties otherwise agree). 12 Cf. Robert S. Summers, AGood Faith@ in General Contract Law and the Sales Provisions of the Uniform Commercial Code, 54 Va. L. Rev. 195 (1968). 13 Economic scholars have become enamored of analogizing many contract terms and doctrines to options. See generally Avery Katz, The Option Element in Contracting, 90 Va. L. Rev (2004). While the analogies can be enlightening, one danger of them is that they too casually smuggle the strict liability connotation of options to other areas where plausible arguments can be made for fault-based approaches. That is, option analogies put the strict liability rabbit in the hat. 14 The classic statement remains Cardozo=s: AFrom the conclusion that promises may not be treated as

25 dependent to the extent of their uttermost minutiae without a sacrifice of justice, the progress is a short one to the conclusion that they may not be so treated without a perversion of intention.@ Jacob & Youngs, Inc. v. Kent, 129 N.E. 889, (NY 1921). 15 R2d ' Charles J. Goetz & Robert E. Scott, Enforcing Promises: An Examination of the Basis of Contract, 89 Yale L.J (1980). 17 See, generally Cohen, Negligence-Opportunism Tradeoff, supra note 2; see also e.g., UCC '' 1-201(16) (defining Afault@ broadly as Awrongful act, omission or breach@); 2-613, cmt. 1 (fault includes both negligence and wilful wrong). 18 See Cohen, Fault Lines, supra note 2, at. 19 Charles J. Goetz & Robert E. Scott, The Mitigation Principle: Toward a General Theory of Contractual Obligation, 69 Va. L. Rev. 967 (1983). 20 See, e.g., R2d ' 49 (offeree cannot accept beyond deadline if offeror negligently delayed in communicating the offer but offeree knows or has reason to know of the delay), ' 153 (allowing relief for unilateral mistake if the other party had reason to know of the mistake or his fault caused it) 21 Schwartz & Scott, supra note 8, at. 22 The fact that the excuse doctrines involve an absence of fault does not mean that their very existence disproves a strict liability theory of contract. The absence of fault is necessary but not sufficient for these doctrines to apply. See Smith, supra note 6, at See UCC (allowing excuse if Agoods suffer casualty without fault of either party@); R2d '' 261 (allowing excuse if Aa party=s performance is made impracticable without his fault@), 265 (allowing excuse if Aa party=s principal purpose is substantially frustrated without his fault@), 157 (mistaken party=s fault bars excuse if Ahis fault amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing,@ but not if fault is simply Ain failing to know or discover the facts before making the contract@). 24 The Restatement writers do use the term Afault@ in comment d to ' 20 (describing the Abasic principle@ of Hosted by The Berkeley Electronic Press

26 the section as being that Ano contract is formed if neither party is at fault or if both parties are equally at but there is a contract if Aboth parties are not equally at fault@). 25 See, e.g., In re Hub Recycling, Inc., 106 B.R. 372 (D.N.J. 1989) (applying ' 201 to interpret insurance company=s Pollution Exclusion Clause, which defined pollutant to include Awaste, including materials to be recycled,@ as applying to recycled material only if it was an irritant or contaminant, on ground that insurance company knew that insured company was in the recycling business). The Restatement rules on trade and other usages, which are essentially particular applications of ' 201, also incorporate a Aknow or has reason to know@ standard. R2d '' 220, 221, 222; see also UCC ' 1-205(3) (trade usage of which the parties Aare or should be aware@ can be used to interpret the agreement). R2d ' 211(3) applies a similar standard to standardized agreements. If the party who drafts the standardized agreement Ahas reason to believe@ that the other party would not have agreed to a particular term if he knew it was there, the term is excluded from the agreement. 26 R2d ' 19(2). In addition to the Aknow or reason to know@ standard, the objective theory uses the term A justify@ to open the door to fault considerations. See '' 2 (promise defined as a manifestation of intent Aso made as to justify a promisee in understanding that a commitment has been made@); 24 (similar definition of offer). 27 For a recent critique of the objective theory sounding some similar themes, see Lawrence M. Solan, Contract as Agreement, 83 Notre Dame L. Rev. 353 (2007). 28 In some situations the Aknow or has reason to know@ standard serves a somewhat different function, albeit still fault-based. When a party knows or has reason to know of special needs of the other party, the party with knowledge may have an obligation to take special precautions to protect the other party from harm. See UCC '' (reason to know creates implied warranty of fitness), 2-715(2)(a) (seller=s reason to know of buyer=s general or particular requirements and needs makes seller potentially liable for consequential damages); cf. R2d ' 351(1) (A reason to foresee@ standard). 29 R3d Agency ' 5.03 & cmt. (d)(1) (A[F]acts known to a contracting party may be relevant to interpreting terms in the contract, may establish defenses to duties of performance, and may provide grounds on which the contract may be rescinded. If an agent enters into a contract on behalf of a principal, notice is imputed to the principal of material facts that the agent knows or has reason to know.@).