Учебный год 22-23 / Binding Promises - The Late 20th-Century Reformation of Contract Law-1

the dye was not defective. The dye manufacturer could not have eliminated the propensity to produce an uneven color at a reasonable cost, and it had given the garment manufacturer fair warning. For example, one would not consider a can of gasoline defective if it exploded when the buyer doused a cigarette in it, despite a warning that it was flammable. Thus, a court could avoid making careful garment manufacturers cross-subsidize careless ones by any of these concepts or doctrines.

My second illustration is the foreseeability rule, which is especially pertinent in contractual situations. It dates from an 1854 English decision, Hadley v. Baxendale.98 The defendant was a carrier that failed to deliver the plaintiff’s mill shaft to a repair shop and back as promptly as it should have. The plaintiff’s mill was shut down for several days as a result. The court held the carrier not liable, even though the delay was a breach of contract, because it was not reasonably foreseeable that a mill owner would fail to have extra shafts on hand to replace those it had to remove for repairing. Thus, farsighted millers who kept extra shafts on hand did not have to cross-subsidize shortsighted millers who did not.

One of the commentators who makes the cross-subsidization argument illustrates it with a hypothetical example indistinguishable from Hadley. Daniel S. Schecter posits two widget manufacturers, Speedy Widget Supply and Long-Term Widget Manufacturing Company. Speedy sells its widgets to a Japanese firm that needs them exactly on time, because it operates with “zero inventory.” Long-Term sells its widgets to an American firm, which is content to have only quarterly deliveries because it carries a large inventory. Neither Speedy nor Long-Term keeps extra widgetmaking machines on hand in case some break down. Acme Widget Machine Company makes the widgetmaking machines that both Speedy and Long-Term use. Both widget manufacturers have one of their widgetmaking machines break down, and both send the broken machines back to Acme for repair. Acme takes too long to repair and return both of them, but only Speedy incurs large consequential damages, because only Speedy incurs a large breach of contract liability to its customer (the Japanese firm) for delivery delays.

Schecter concludes that the law should have allowed Acme to exclude liability for consequential damages, because otherwise firms such as LongTerm will cross-subsidize firms such as Speedy. He is forgetting the foreseeability rule, however. A court presumably would deny Speedy’s claim on the authority of Hadley. Under the circumstances (i.e., Speedy’s having a “zero inventory” customer) Acme could not reasonably foresee that Speedy would not have kept some spare widgetmaking machines in its machinery inventory.99

None of this is to say that a lawmaker should ignore cross-subsidization because it is never a problem. Of course it can be a problem under some

circumstances. In particular, a court should ordinarily allow a buyer and seller to contract for weaker warranties in exchange for lower prices if the seller can prove that the buyer had about equal bargaining power on the matter, that is, if the seller can prove that the buyer sufficiently understood what he was risking to have made an informed and intelligent choice to give up his protection in exchange for lower prices. Courts often allow parties to contract out of traditional tort liabilities one of them would normally have to the other upon a showing that the party who gave up his tort-law protections understood the risk he was taking.100 They could grant the same allowance to buyers and sellers with respect to warranties and other relational-tort duties.

Acceptance

With but one exception, there is a relational tort in at least one jurisdiction for every kind of product, and there are numerous and comprehensive relational torts for insurance and manufactured products in every jurisdiction. Courts have created relational torts for dwellings and services both as laws applicable to these things generally and as laws that apply only to certain products or in certain situations. Examples of the latter are the relational torts for employment, construction services, brokers, fiduciary relationships, and discretionary contract powers. The one exception is for buildings that are not dwellings, and even this exception is probably only apparent. A person who wants such a building ordinarily hires a general contractor and possibly an architect to build it instead of buying it from a developer already made. The laws of professional malpractice already cover architects, the relational torts for construction services already cover the services of general contractors, and the courts will probably hold that the laws of professional malpractice cover general contractors as soon as the cases come to them.

Relational torts cover many of the same situations as does the law of reasonable expectations. I will treat the connections between relational torts and reasonable expectations in Chapter 7.

5

Bad Faith Breach and Remedies Reform

ALTHOUGH NOT EVERY court would define bad faith breach quite the same way, the consensus is that a breach of contract is in bad faith if the breacher knows he has no defense but still tries to avoid liability. A bad faith breach is a tort. In addition to the usual damages for breach of contract, the injured party can recover damages for emotional distress and punitive damages. In a growing number of jurisdictions, he can also recover his litigation costs. Courts now also award some of these additional damages in contract actions not involving a bad faith breach; this is the remedies reform to which I refer in the chapter title.

The Birth of Bad Faith Breach in California

The tort of bad faith breach was “born” in many states in the 1970s and 1980s. I will describe its development just in California, because I am most familiar with its development there and because the California courts took a leading role in its development, although by no means an exclusive one. I described the California Supreme Court’s 1958 decision in Comunale v. Traders and General Insurance Co.1 in Chapter 4. The court there held that a liability insurer must accept a reasonable settlement offer from a liability claimant. The court also held that the covenant of good faith and fair dealing sounded in both contract and tort. This part of the holding was almost offhand, the court’s purpose being to avoid having to decide which statute of limitations applied to the plaintiff’s claim, but it proved to be of crucial importance for the development of bad faith breach.

California law, like that of virtually every state in the 1960s, forbade recovery of damages for emotional distress in contract cases unless the contract was “for the protection of personal interests”2 and forbade recovery of punitive damages in any contracts case.3 The category of “for the protection of personal interests,” with rare exceptions, was limited to contracts of just three kinds: contracts for funeral arrangements, contracts for plastic surgery, and contracts for food or lodging where the breach consisted of an insulting, or at least unwarranted, ejection from the premises.4 Still more limitations were imposed in practice. A plaintiff could not recover unless he could show that the defendant’s conduct was outrageous

and his emotional distress severe. The requirement of severity probably derived from the rule that the plaintiff in a contracts case prove his damages to a reasonable degree of certainty.5 A person could recover punitive damages only for a tort, and even then, only if the tort was of a certain kind or if the conduct of the wrongdoer was especially bad.6

Comunale opened up the possibility of avoiding these traditional limitations and recovering damages for emotional distress and punitive damages in a contracts case, because the state supreme court had held there that the covenant of good faith and fair dealing is implied in every contract. No one thought the court had meant to say that every breach of contract is also a tort, but there was nothing to do but to try to reason how far the court would go until the court spoke again on the matter. In the meantime, all that was clear was that the covenant sounded in both contract and tort in a liability insurance case, because Comunale was a liability insurance case. Nine years after Comunale, in 1967, the court held again that the covenant sounded in both contract and tort in another liability insurance case but gave no hint of where else it might do so.7 This was the situation when two intermediate appellate courts decided cases involving disability insurance.

Fletcher v. Western National Life Insurance Co.8 was decided in 1970. Wetherbee v. United Insurance Co.9 was decided in 1971. Judge Marcus M. Kaufman wrote the court’s opinion in Fletcher, and Judge Daniel R. Shoemaker wrote the court’s opinion in Wetherbee. Both decisions have been influential in and outside of California to this day, but for the sake of brevity I will only treat Fletcher.

The insured, U. L. Fletcher, had left school after the fourth grade. He supported a family of ten by working seventy to eighty hours a week as a scrap operator for a rubber company. He owned his home and some real estate in Arizona. His disability insurance promised him $150 a month for up to thirty years if he became “totally disabled” as a result of an accident. While working, he suffered a back injury from lifting a 360-pound bale of rubber. The physicians who examined him concluded he was totally and permanently disabled. Nevertheless, his insurer, Western National Life, wrote to him that it had concluded his ailment was a “mild form of glanders . . . contracted from horses” rather than a result of an accident. They accused him of failing to disclose this “congenital back ailment” when he purchased his insurance and demanded he pay back the slightly less than $2,000 they had already paid him, less the premiums he had paid before he became disabled. Left without either wages or insurance benefits, Fletcher used up his savings, sold his property in Arizona, and put himself and his family on a nearly all-starch diet. Mrs. Fletcher found a job, he cared for the children, and some of their friends gave them money, but they still could not make ends meet. Their utilities were eventually cut off for nonpayment.

Fletcher sued and won a verdict of $60,000 compensatory damages and $640,000 punitive damages against Western and $10,000 punitive damages against the Western supervisor who had handled the case. The court reduced the punitive damages against Western to $180,000 and struck those against the supervisor upon Fletcher’s agreement to accept the reductions in lieu of a new trial. The court of appeals affirmed on two grounds. It held that the covenant of good faith and fair dealing sounded in both contract and tort in a disability insurance case, and it held that Western had committed an included tort. A defendant in a contracts case commits an “included tort” if his conduct in connection with the breach constitutes an ordinary tort. The court of appeals held that Western had committed the ordinary tort of intentional infliction of severe mental distress. This tort has three elements. The defendant must have intended to cause the mental distress, his conduct must have been “outrageous,” and the mental distress must have been severe.10 Western did not appeal, so the California Supreme Court did not have an opportunity to affirm or reverse on either ground. However, in 1973 the California Supreme Court affirmed a decision resting on the same two grounds by holding that either one was sufficient to support an award of damages for emotional distress and punitive damages.11

The principal unanswered question after 1973 was whether the covenant ever sounded in tort as well as in contract in relationships other than insurance relationships. The California Supreme Court did not give an answer until Seaman’s Direct Buying Service, Inc. v. Standard Oil Co.,12 in 1984. Seaman’s was a retailer of supplies for ships and boats. The city of Eureka, California, planned to build a new marina in which there would be space for a fuel station for boats. Seaman’s and Eureka negotiated a contract under which Eureka would lease space in the new marina to Seaman’s for selling boat fuel, but the contract was conditional on Seaman’s providing proof that it had obtained a fuel dealership from a reputable wholesale fuel supplier. Seaman’s signed a dealership contract with Standard and presented a copy to Eureka as proof, on the basis of which Eureka gave Seaman’s the lease. However, before Eureka completed the construction of the marina, the worldwide oil shortage of 1973–1974 started.

The federal government limited oil companies to supplying the customers they already had unless they obtained individualized exceptions, called supply orders. With Standard’s assistance, Seaman’s applied for and was granted a supply order, but Standard then changed its mind and appealed to the next higher level in the federal agency to revoke the order, taking the position that it did not have a binding contract with Seaman’s. Standard won the appeal, but Seaman’s took an appeal to a still higher level and got the agency to reinstate the order. However, the agency conditioned the reinstatement on Seaman’s obtaining a court decree that its contract with

Standard was binding. Seaman’s asked Standard to stipulate to the fact, because Seaman’s could not stay in business without fuel supplies for the time it would take for a trial. The Standard officer involved reportedly laughed and said, “See you in court.”13 Seaman’s went out of business and lost its lease with the city of Eureka.

Seaman’s sued Standard, claiming breach of contract, violation of the covenant of good faith and fair dealing sounding in tort, and tortious interference with its business relationship with Eureka. It won on all counts in the trial court. The jury awarded Seaman’s $397,050 compensatory damages for breach of contract, $1,588,200 in compensatory damages for intentional interference with advantageous business relations, and $11 million in punitive damages on both the bad faith and the interference counts, for a total of $23,985,250. The court ordered a new trial unless Seaman’s would agree to reductions of the punitive damages on the bad faith count to $1 million and on the interference count to $6 million. Seaman’s agreed to the reductions.

Standard appealed all the way to the California Supreme Court. The court affirmed the breach of contract count but reversed and ordered a retrial on the other two. The retrials, however, were solely for findings of fact. The court held that the plaintiff’s allegations on the last two counts were sufficient as a matter of law.14 Standard settled with Seaman’s for $4.5 million rather than relitigate the case.15 I will say no more about the count of tortious interference, because it lies outside our concerns. The court’s decision on the violation of covenant count was unanimous except for a concurrence by Chief Justice Rose Bird, who construed the tort even more expansively than the rest of the court did. Marcus M. Kaufman, the author of the opinion in Fletcher, was now a justice of the California Supreme Court. However, neither he nor any of the other justices signed the court’s opinion, which was simply labeled, “By the Court.”

The court held that a breach of the covenant is also a tort, generally at least, if it occurs within the “‘special relationship’ between insurer and insured” or within “other relationships with similar characteristics.” The characteristics that make the relationship of insurer and insured “special” are its possession of “elements of public interest, adhesion, and fiduciary responsibility.”16 The relationship between Seaman’s and Standard was not “special” because it lacked these elements. Their contract was only an “ordinary commercial contract.” Nevertheless, the court held that the covenant would still sound in tort in this case if Standard’s breach of the contract possessed certain characteristics. The only authority the court cited for these characteristics was a 1976 decision by the Supreme Court of Oregon, Adams v. Crater Well Drilling, Incorporated.17 One needs to understand Adams in order to understand the California Supreme Court’s decision on this point.

Crater drilled a well for Adams under a contract that provided for a price of $4 a foot unless Crater encountered hard rock, in which case the price was to be $8 a foot. Crater found water at 500 feet and billed Adams at the rate of $8 a foot for all but 63 feet of the depth, claiming that the other 437 feet were hard rock. Adams disbelieved Crater and gave him a check for $2,000, saying that was all he owed. Knowing that Adams’s wife was critically ill at the time and that she was fearful of litigation, Crater threatened to take Adams to court for the balance. Adams gave Crater a second check for the balance but sued him for restitution after his wife had recovered. The jury returned a verdict for Adams, agreeing with him that none of Crater’s drilling had been through hard rock, but the trial court set the verdict aside.

The Oregon Supreme Court reinstated the verdict for Adams on the ground that he paid Crater the extra amount under duress. A person performs an act under duress if he had no reasonable alternative to performing it, and the absence of reasonable alternatives was a result of the other person’s wrongful threat or act. Adams’s wife’s illness and her fear of litigation left him no reasonable alternative to making the payment. Crater’s threat of suit was wrongful because he made it “‘without probable cause and with no belief in the existence of the cause of action.’”18

Several years after Seaman’s was decided, I asked one of the California Supreme Court justices why no one had signed the opinion. He replied that it was because none of them knew what to make of the “odd little Oregon case,” which was the only precedent they had for their holding. Odd or not, the California Supreme Court put the case to effective use. The court said:

There is little difference, in principle, between a contracting party obtaining excess payment in such manner, and a contracting party seeking to avoid all liability on a meritorious contract claim by adopting a “stonewall” position (“see you in court”) without probable cause and with no belief in the existence of a defense. Such conduct goes beyond the mere breach of contract. It offends accepted notions of business ethics. [citing Adams]. Acceptance of tort remedies in such a situation is not likely to intrude upon the bargaining relationship or upset reasonable expectations of the contracting parties.19

Although the court here phrased the test of bad faith as whether the breach was without probable cause and with no belief in the existence of a defense, there are other indications in the opinion that an absence of a belief in a defense is enough. The court at several points seems to say this, using such terms as “belief” or “good faith,” standing alone.20 More important, Standard pleaded in defense that the contract was not binding because it was not definite enough to satisfy the Statute of Frauds. Although the court found that the contract was definite enough,21 such a finding does not mean that the alleged lack of definiteness did not constitute a probable cause, and

the court never said it did not. Among the reasons the court gave for ordering a retrial on the count of bad faith was that if the jury were to conclude that Standard had the Statute of Frauds ground in mind when it denied to the federal agency that it and Seaman’s had a binding contract, Standard would not have acted in bad faith.22 It logically follows that if Standard did not have this defense in mind when it denied the existence of a binding contract, it was acting in bad faith—even though the defense was a probable cause. In other words, a lack of a belief in a defense is enough; a defense that actually constitutes a probable cause is irrelevant unless the breacher is aware of it.

The court characterized Standard’s conduct as an attempt to escape all liability on the contract. However, any doubts that the tort of bad faith breach might not include attempts to escape only some liability were removed in future years, when the court affirmed decisions involving only such partial attempts.23 Thus bad faith breach was eventually established in California to be simply an attempt to avoid liability on a contract without an honest belief in a defense.

The bad faith decisions up to and including Seaman’s allowed recoveries of damages for emotional distress and punitive damages in addition to the traditional damages for breach of contract. The California Supreme court added the winning plaintiff’s litigation costs in Brandt v. Superior Court24 in 1985. It supported the addition on two grounds. The first was an analogy to an automobile accident victim’s recovery of his medical costs. The court said that the victim of a bad faith breach is just as much required to pay a lawyer to rectify the effects of the breach as the victim of an automobile accident is required to pay a physician to mend his or her injuries. This makes a sound argument in principle, but the compensation principle was not the problem. The problem was the American Rule, which prohibits the recovery of litigation costs even though they are a proximate cause of the defendant’s wrongful conduct.

The second ground was an analogy to the tort of malicious prosecution. This tort is committed if one person induces a public prosecutor to bring criminal charges against another person or himself brings a civil action against another person, in either case without a probable cause or a belief in the basis of the charges or civil action. A victim of this tort can recover the costs of defending himself against the criminal charges or the civil action, and, of course, these costs ordinarily include attorneys’ fees.25 This is a valid analogy. Indeed, malicious prosecution and bad faith breach as the court defined it in Seaman’s are almost opposite sides of the same coin. A person commits the tort of malicious prosecution if he brings a civil action without probable cause or a belief in the basis of the action and commits the tort of bad faith breach if he defends against a contract action without probable cause or a belief in the basis of the defense. Malicious

prosecution consists of dishonestly bringing a claim. Bad faith breach consists of dishonestly defending against one.

However, the victim of a malicious prosecution must bring a separate action to recover the litigation costs he incurred in the criminal or civil actions he had to defend against. It is this fact that avoids the operation of the American Rule, which only prohibits a defendant from recovering his litigation costs in the same action. The plaintiff in a bad faith action, on the other hand, would be recovering litigation costs incurred in the same action. The defendant in Brandt pointed out this difference, but the court rejected it as merely procedural and noted that it would be wasteful to require a plaintiff to bring a second action to recover his litigation costs. However, the court stayed as close to the analogy to malicious prosecution as it could by limiting the recovery to just the litigation costs the plaintiff incurred in the contract part of the action. A plaintiff could not recover the litigation costs he incurred in proving that the defendant had committed the tort of bad faith breach.26

The court confused the matter just a year later, however, in White v. Western Life Insurance Co.,27 by affirming a plaintiff’s recovery of all his litigation expenses in a bad faith action without comment. This was in 1986. Surprisingly, as of the mid-1990s, there has been no other reported state court decision on the point. Attorneys have told me that there are trial court decisions going both ways, with perhaps those allowing full recovery in the majority. In 1993, the U.S. Court of Appeals for the Ninth Circuit, applying California law, enforced the limitation, citing only Brandt, and denied the plaintiff’s request for leave to amend on the ground that the law on the point was too clear to excuse overlooking it.28 The denial of the request for leave to amend seems a bit harsh under the circumstances.

The court did not elaborate in Brandt on the analogy between bad faith breach and malicious prosecution. Judge H. Walter Crosskey of the California Court of Appeal articulated the analogy in a carefully reasoned manner in 1990, in Careau & Co. v. Security Pacific Business Credit, Inc.29 The analogy to malicious prosecution has the advantage over the analogy to duress that the California Supreme Court offered in Seaman’s of including a justification for allowing the plaintiff to recover litigation costs, but apart from this, the analogies seem equally persuasive. However, recoveries of litigation costs ought not to require special justification. The winning party ought to recover his litigation costs from the loser in any case, as we will see presently.

Seaman’s and its progeny were unpopular among defense lawyers, especially those who represented insurance companies.30 Some published comments went so far as to find in Seaman’s a license to award damages for emotional distress and punitive damages in any contracts case.31 There was a nationwide insurance crisis in the early 1980s, in which prices for

liability insurance skyrocketed and some kinds of liability insurance were unavailable at any price. Many people blamed the changes in the law that permitted higher damages awards. In California, these concerns coincided with concerns about the apparent reluctance of the courts to enforce the death penalty, which the state had recently reinstituted. Judges in California have to stand for election only once, a number of years after the governor has appointed them. By coincidence, four of the seven members of the California Supreme Court had to stand for election in November of 1986. Only one of them was elected. Another member of the court resigned shortly thereafter. These losses, plus two other resignations that had occurred earlier, left only one justice on the court in 1987 who had been there since 1981.32

The new court dealt with bad faith breach in 1988 in Foley v. Interactive Data Corp..33 Foley’s employment contract with Interactive was terminable at the will of either party. Foley nevertheless claimed that Interactive’s termination of him was wrongful because it was tortious. He alleged that Interactive acted for reasons that violated public policy and that the covenant of good faith and fair dealing made any termination from employment without good cause tortious. The court recognized the validity of the public policy claim but ruled that Interactive had not violated public policy, and it declined to recognize the claim resting on the covenant of good faith and fair dealing. Although Foley characterized Interactive’s actions as being in bad faith, nothing in the situation presented a question of bad faith breach as the court had developed that tort in its previous decisions.

The justices nevertheless quarreled about the elements of bad faith breach. The quarrel was not even on the merits. It was on what the court had meant in its opinion in Seaman’s. A four-to-three majority in Foley said the Seaman’s court had meant that a person can commit a bad faith breach of an ordinary commercial contract only by denying in bad faith the contract’s existence. A bad faith assertion of a defense is not enough.34 This interpretation is absurd. It rests on a single statement in the opinion, in which the court referred to Standard’s denial of the existence of a contract with Seaman’s, although there are seven other references on the same page to a person’s denial of the existence of a “binding,” “meritorious” or “valid” contract, his liability under a contract, or the existence of a defense.35 The interpretation also contradicts the court’s instructions to the trial court on remand about the effect it was to give to Standard’s belief, or lack of belief, in a Statute of Frauds defense.36 Needless to say, Foley caused a great deal of confusion.

Despite Foley, however, all California courts continued to recognize some form of bad faith breach, and some continued to recognize it as the California Supreme Court actually held in Seaman’s,37 until the court overruled Seaman’s in Freeman & Mills, Inc. v. Belcher Oil Co.38 in 1995. The