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

court gave as reasons for the overruling the widespread confusion that had arisen over Seaman’s, compelling policy reasons for precluding tort remedies in contractual situations, and the fact that no other state except Montana had recognized the tort of bad faith breach in commercial contracts. None of the reasons is persuasive. It was Foley that created most of the confusion about Seaman’s, and in any event, the logical remedy for confusion over a decision is to dispel the confusion, not to overrule the decision if it is otherwise a wise one. The so-called compelling policy reasons were either restatements of the old notion of classical contract that tort and contract law should be rigidly separated or more claims that Seaman’s was confusing. Finally, it is not true that no other state except Montana recognizes the tort of bad faith in commercial contracts. The fact is that sixteen other states recognize it for all contracts or at least a broad range of them, as I will show in the next section. In any event, the decision is unlikely to greatly reduce the volume of punitive damages claims in contract cases, as the court presumably intended, because many bad faith cases can be grounded on fraud instead, which also entitles a plaintiff to punitive damages. For example, the defendant in Seaman’s committed a fraud when it knowingly falsely denied having a binding contract with the plaintiff.

Bad Faith Breach Nationally

Despite many questions of interpretation, it is fair to say that thirty-six jurisdictions now recognize a tort of bad faith breach substantially as the California Supreme Court defined it in Seaman’s. I count a law to be substantially like California’s was before Freeman & Mills changed it if the law imposes a nonwaivable duty not to breach in bad faith and if the offending party is liable for punitive in addition to compensatory damages under aggravated circumstances, whether or not the jurisdiction uses the name “bad faith” or characterizes the law as a tort. However, most of these jurisdictions still do not allow the tort the full scope of application California did. Sixteen recognize it for all contracts or at least a broad range of them.39 Nine, counting California, narrowly confine it, usually just to insurance contracts.40 Thirteen have not yet ruled on the scope question.41 Only the supreme courts of Pennsylvania42 and Utah43 have declined to recognize the tort of bad faith breach or anything like it for any contracts, thus leaving eleven jurisdictions in which the question is still open.44 It is practically impossible to determine the number of states that currently allow recoveries of litigation costs in bad faith actions, because the commercial legal digests do not categorize reported decisions in a manner that enables one to identify these decisions. However, the West Corporation recently created a category for recoveries of litigation costs by insureds

whose insurers delayed or refused payment of claims, from which one can determine that at least thirty-three jurisdictions now allow such recoveries in these cases.45

A few states define the tort even more broadly than the California Court did in Seaman’s. For example, in a series of decisions dating back to 1976 the Indiana Supreme Court has allowed punitive damages in a contract case if the breach was “tortious in nature” or if “‘elements of fraud, malice, gross negligence or oppression mingle in the controversy’” (emphasis in original). It is enough if the defendant’s behavior was deceptive or fraudulent “in nature,” even if the requirements of common law fraud are not met. This is especially so if the defendant was in an occupation or otherwise in a position in which the public must necessarily place a high degree of trust. The court found such a degree of public trust in members of the insurance industry and of the construction industry. However, in one case the losing defendant was an automobile dealer, and the court did not say that automobile dealers are recipients of the public trust.46

But verbal variations do not seem to matter. If one applies the Seaman’s definition to the facts, the results generally are the same as those the court reached, no matter what verbal formulation it was using. An Indiana case,

Hibschman Pontiac, Inc. v. Batchelor,47 makes a good illustration. Batchelor took his new car back to Hibschman, the dealer from whom he had bought it, for warranty work five times within the first month after it was delivered to him and eventually twelve times for overnight work and twenty times in all. Much of the work supposedly done was for work the dealer’s service manager claimed already to have done on previous occasions. Yet each time Batchelor came to pick up his car, the service manager told him it was “‘ready to go.’” When at last Batchelor went over the head of the service manager to complain to the next in command, he was told, in effect, to stop bothering them. The Indiana Supreme Court affirmed an award of punitive damages on the ground that there was “cogent proof to establish . . . fraud . . . and oppressive conduct,” among other things.48 The elements of a bad faith breach as Seaman’s defined it are easy to see. The car dealer had a contractual obligation to deliver a car in good working order or to do the warranty work in a workmanlike manner if the car was not in good working order when it was delivered. It failed on both counts but sought to avoid liability for its failures without an honest belief in a defense.

John A. Sebert, Jr., published a pioneering work on the new contract damages entitlements in 1986.49 He surveyed contract cases in which the courts had awarded “nonpecuniary” damages, by which he meant damages that were compensatory but not for an objectively measurable economic loss. Damages for emotional distress are an example. This criterion included the bad faith breach cases and also cases in which the courts had

awarded nonpecuniary damages for included torts. Sebert found decisions awarding nonpecuniary damages in twenty-one states.50 Michelle A. Harrington published a similar survey in 1989 in which she added eight more states to the twenty-one Sebert had found.51 Harrington also found lower court decisions awarding punitive damages or at least saying they were available in contract cases in six states.52 Although Sebert’s and Harrington’s criteria included more decisions than just those recognizing bad faith breach, the difference between 1995 and 1986 is remarkable even without taking this fact into account. The number of jurisdictions recognizing the tort of bad faith breach (in substance if not in name) went from twenty-one or less to thirty-seven in only nine years.

Justifications

Why is a bad faith breach worse than an ordinary breach? The California Supreme Court said in Seaman’s that it is because a bad faith breach “offends accepted notions of business ethics.”53 This is probably true, but it does not get us very far, because it does not tell us why bad faith breaches offend these notions.

The additional wrongfulness that is not present in every breach is the breacher’s dishonesty. The breacher does not just violate a contractual duty—he knowingly violates the duty. He knows he has no defense or, as courts sometimes put it, he “lacks an honest belief in a defense.” Such conduct is not necessarily dishonest in the sense of lying, although the bad faith breacher lies if he claims to have a defense. It is dishonest in the broader sense of knowingly violating a legal or moral norm to obtain an advantage at the expense of another. It is dishonest as robbery or extortion is dishonest, for example. A robber or extortionist may be quite honest in what he says to his victim, but he takes or extorts something that rightly belongs to the victim, and he knows that what he is doing is wrong. What the bad faith breacher knowingly wrongfully takes is his victim’s contract rights.

One must understand contractual duty in this context to be the duty to perform a contract or compensate the other party for not performing it. Not even in a perfect world would people always perform their contracts, because under some circumstances all concerned are better off if the parties to a contract do not perform it. However, ordinarily at least, the other party will be worse off unless the breacher compensates him. The bad faith breacher’s attempt to avoid liability for his breach distinguishes a bad faith breach from what economists call an “efficient breach” of contract, in which although the breacher breaches knowingly, he voluntarily compensates the other party.54

The law traditionally punishes knowing violations of duties more severely than unknowing or accidental ones. Presumably the reason is that knowing violations generally inflict public injuries in addition to the injuries they inflict on their victims. They undermine the mutual trust that people need to compose a civilized society. In addition, as Judge Crosskey noted, bad faith breaches inflict a public injury similar to that inflicted by malicious prosecutions.55 The public maintains judicial systems at substantial expense. Jurors and others contribute long periods of time to them for little or no money. For civil laws, the principal purpose of a judicial system is to resolve disputes. People abuse them when they use them to obligate others dishonestly (malicious prosecutions) or to avoid their own obligations by dishonest means (bad faith breaches).

The reasons why bad faith breaches are worse than ordinary breaches have nothing to do with the kind of contract concerned or the industry of which the producer party to the contract is a member. Therefore, as lawyers and judges come to understand the tort more fully, one can expect that the courts will eliminate the limitations that currently exist in some jurisdictions on when the tort is recognized. In the late 1980s and early 1990s, courts in some of the jurisdictions where the tort was still limited, or largely limited, to insurers took a step toward eliminating these limitations by recognizing that an insured can also commit the tort.56 The justifications for limiting bad faith breach to insurers are the same as the justifications for limiting relational torts to insurers, which were treated in Chapter 4, but these justifications do not support extending the tort to insureds.

Some have criticized bad faith breach as too vaguely defined and as leaving juries too free to make large damages awards.57 Judge Alex Kozinski once called it “a cause of action so nebulous in outline and so unpredictable in application that it more resembles a brick thrown from a third story window than a rule of law.”58 The charges of vagueness were premature. Many of the courts that used the phrase “bad faith breach” a decade or more ago used it without clearly defining it, but in recent years courts have given it just as precise a meaning as they give traditional doctrines.

However, there is still some confusion in allocating functions between judge and jury. Whether the defendant had an honest belief in a defense is a question of fact, which most judges have therefore left to the jury. The jury will not be capable of rendering a competent decision, however, if the answer depends on whether a defense the defendant offered had a reasonable basis in law and fact, and the answer does depend on such a determination in many cases. Although it is possible that a person who offers a defense that has a reasonable basis in law and fact does not have an honest belief in it, under ordinary circumstances the possibility is so remote that the judge ought not to let the jury speculate on it. Moreover,

the judge rather than the jury should decide whether a defense had a reasonable basis in law and fact, if that is an issue, in every case, because the decision requires a legal judgment. It is settled law, for example, that the judge rather than the jury makes these determinations in a malicious prosecution case.59

Tan Jay International, Ltd. v. Canadian Indemnity Co.60 is a case in which the trial judge seems to have done everything wrong in this respect. He left it to the jury to decide whether the insurer’s defense of no coverage had a reasonable basis in law and fact, and he allowed the jury to find that the insurer did not have an honest belief in the defense even if the defense had a reasonable basis in law and fact. In Seaman’s, on the other hand, the California Supreme Court did everything right in this respect. When the Court remanded the case for a jury determination of whether the defendant had been aware of its statute of limitations defense when it denied it had a binding contract with the plaintiff, the court limited the jury to this determination. It did not order the trial judge to allow the jury to decide whether the defense had a reasonable basis in law and fact, and it did not order the trial judge to allow the jury to decide whether the defendant lacked an honest belief in the defense even if he was aware of it.

If juries make damages awards too large in bad faith cases, the fault lies with the substantive or procedural controls over the damages awards, not with the tort of bad faith breach. A jury has no more discretion over how much to award for emotional distress or as punitive damages in a bad faith case than it does in any other case where the law allows these kinds of damages.

Bad Faith beyond Contract

A person can commit the same kind of wrong he would commit with a bad faith breach although the duty he fails to perform is not a contractual duty. All that is required is that he knows he has no defense and nevertheless seeks to avoid liability. For example, a manufacturer would violate the law of product liability in bad faith if it knowingly marketed a defective product and sought to avoid liability for the resulting personal injuries and property damage. Courts have already used the concept of bad faith in connection with violations of relational torts, although they have generally clouded the fact by calling the violation a breach, either of the contract or of the covenant of good faith and fair dealing.61 We should recognize the tort wherever a person commits it. It would help if we reserved “breach” for commissions of the tort in connection with breaches of contract and said simply “bad faith” in other cases.

Recovery of Litigation Costs: The American Rule

Litigation cost recoveries are necessary to make the winning plaintiff’s compensation complete. A person who was wrongfully injured is not fully compensated unless his compensation includes his costs of litigation, if he had to litigate in order to recover compensation for his initial injuries. The inclusion of litigation costs among the damages for bad faith breach needs no more justification than this. What needs justification is the American Rule. Why can’t the winner recover his litigation costs in every case? The rule in the rest of the world is that he can. I will treat this rule first, because it is the alternative to the American Rule that most commentators suggest. I will treat thereafter the rule that would allow only winning plaintiffs to recover their litigation costs.

When litigation costs are recoverable, the recoveries are subject to all the legal requirements for recoveries of other kinds of losses: causation, certainty, foreseeability, and mitigation, for example. Two important rules follow from this fact. One is that the winner can recover his litigation costs only to the extent they were reasonable, because the loser did not cause them to the extent they were more than reasonable. This limitation applies both to the lawyer’s hourly rates and to the time he or she spent on the case.62 This rule has the salutary effect of maintaining the costs of litigation at reasonable levels, from which both the parties and the public benefit. The public benefits because unnecessarily lengthy litigation imposes unnecessary costs on the judicial system.

Another rule that follows from these legal requirements is that a plaintiff can recover his litigation costs only to the extent they were necessary to recover his other damages. For example, a plaintiff who wins no more in court than the defendant offered to settle for before the plaintiff’s lawyer began preparations for trial cannot recover for the costs incurred after the lawyer began preparations for trial.63 This rule encourages defendants to make fair settlement offers and plaintiffs to accept them. It increases the amount each will lose if he fails to act fairly. For obvious reasons, this rule also discourages either party from using tactics intended to increase the other’s costs of litigation.

Countries that generally allow litigation cost recoveries also generally prohibit contingent fee arrangements, but this fact does not reflect any logical necessity. We could continue to allow contingent fee arrangements in cases for which we had abolished the American Rule if we chose to. However, we would have to make certain adjustments. The amount of litigation costs a winning plaintiff would recover would be the same whether or not he and his lawyer had a contingent fee arrangement. The plaintiff would

recover only the reasonable litigation costs in either case. If it were otherwise, there would be nothing to discourage plaintiffs’ lawyers from charging exorbitant percentages. The percentages would cost the plaintiffs nothing because the defendants would pay them.

We would avoid this problem if we allowed the court to set the percentage after the case was over, but this would not avoid other problems. Plaintiffs who made contingent fee arrangements would still have an advantage over plaintiffs who paid their lawyers; defendants would be more willing to settle with the former, because they would have more to lose if they lost to them. This would be unfair, and it would also encourage all plaintiffs to use contingent fee arrangements, even those who could afford to pay their lawyers and would otherwise prefer to pay them.

A plaintiff with a contingent fee arrangement should have to pay his lawyer the agreed percentage if he wins and receive only the reasonable value of the lawyer’s services on a prepayment basis as damages from the defendant. Such a recovery would leave the plaintiff something short of full compensation and give his lawyer something more than the reasonable value of his or her services on a prepayment basis, but these results would be fair because the lawyer took all the risks of losing, and the plaintiff took none of them.

Lawyers on contingent fees should also be jointly liable with their clients for the other parties’ litigation costs if they lose. This, too, would be fair, because the lawyers’ contingent fees give them a joint economic interest in the case. How the lawyer and client might agree to split the potential liability between them could be left to their discretion, but it seems safe to predict that competition would quickly force most lawyers to agree to shoulder the whole burden. This is also as it should be, because the lawyer is both the better cost-avoider and the better cost-spreader. She or he is the expert, has the experience, and can spread the risk over a number of cases. Law firms that engage in contingent fee litigation typically carry caseloads of dozens and often hundreds of such cases. In personal injury cases, at least, the large majority of contingent fee clients are already impoverished by the event that sent them to the lawyer, so the lawyer would know that as a practical matter he or she had sole financial responsibility anyway.

The lawyer’s joint liability on contingent fee arrangements would also answer the only valid objection I have ever heard against holding losing plaintiffs liable, which is that it would discourage poor or risk-averse people from bringing meritorious cases.64 Because poor people cannot afford to bring a case except on a contingent fee basis, the potential liability to the defendant would have no effect on them. Risk-averse people who were not poor could do the same, and in addition could choose a lawyer

who would agree to take all the risk him or herself. If a poor or risk-averse person could not find a lawyer who would agree to take all the risk, it is right that he not bring his case, because he would have demonstrated by his own choices that he did not believe in his case or care enough about it to take a risk. Legal actions are expensive and disruptive of other people’s lives. The law ought not to encourage people to bring them at no risk to themselves.

The lawyer’s joint liability would also help the client by giving the lawyer an incentive to investigate the merits of a case before agreeing to represent the victim. If the lawyer turned down the case, the victim would be free to try to find another lawyer. Some lawyers regard potential contingent fee clients simply as exploitable resources. They will agree to represent them without first investigating the merits of the case; they may even advertise their services on television and elsewhere, practically promising to represent anyone with the appropriate kind of injury. However, they provide effective representation only to the few whose cases will give them a substantial return on their investment. They give the others little or nothing, even if a serious investigation of their cases would have disclosed they had merit.

Another common argument against litigation cost recoveries is the nearly opposite one that they would increase the volume of litigation, because people who were confident of winning would be even more willing than they now are to bring cases.65 The short answer to this argument is that it is irrelevant. More people should bring cases, if suing is the only way they can enforce their rights. If reducing the volume of litigation were our goal, we could equally well achieve it by reducing or eliminating other kinds of damages. We could limit victims of automobile accidents to recovering only 50 percent of their medical expenses, for example.

However, such empirical research as there has been indicates that litigation cost recoveries would not have much effect either way on the volume of litigation, although they might well (as they should) have some effect on the contents of the volume. For example, we presumably would want to reduce the volume of so-called strike suits, suits without merit brought solely to extort defendants into settling. George L. Priest has done a study of the effects on litigation volume of a change in the law that sharply increased the damages a plaintiff could recover for a certain kind of tortious injury. The immediate impact was to increase the number of claims filed, but the number eventually fell back to what it had been. Presumably the reason is that a potential plaintiff and defendant are likely to litigate rather than settle only when their perceptions of the likely outcome of litigation are far apart. They are likely to settle if their perceptions are not far apart, because settling both increases the plaintiff’s net recovery and reduces

the defendant’s net loss by eliminating the costs of litigation for both of them.66 Thus, when the law changed, plaintiffs’ and defendants’ perceptions presumably changed with it, but they eventually came back into rough agreement again. John J. Donohue III reached the same conclusions Priest did, and for similar reasons.67 The Priest and Donohue studies may not be fully applicable to recoveries of litigation costs, however. At least in principle, no other kind of recovery has the same effects on litigation as do litigation cost recoveries, because no other kind so directly affects the decisions whether to bring a suit and whether to settle one rather than go to trial on it.

Some have suggested lifting the American Rule just for plaintiffs. The rationale is that whereas a plaintiff’s litigation costs are included in the compensation principle because the defendant’s wrongdoing required the plaintiff to incur them, the same cannot be said of the defendant’s litigation costs.68 However, making the plaintiff’s recovery fully compensatory is not the only reason for abolishing the American Rule, and even if it were, abolishing the rule only for plaintiffs would go to the opposite extreme and create a situation generally unfair to defendants. Moreover, abolishing the rule only for plaintiffs surely would increase the volume of litigation. It would increase the amounts plaintiffs stood to win, make defendants more willing to settle, do nothing to increase the risks of plaintiffs’ losing, and do nothing to discourage strike suits.

The Florida Medical Association persuaded the Florida Legislature to abolish the American Rule for medical malpractice cases in 1980. The statute made indigent plaintiffs an exception. The Florida Supreme Court ruled that lawyers for indigent plaintiffs should also be exempt, although they (of course) represented their indigent clients on contingency fee arrangements. The court’s ruling had a large impact, because many plaintiffs in medical malpractice cases can reasonably claim indigence. The statute did not specify whether a winning plaintiff with a contingent fee agreement should recover the contingent fee or a reasonable amount on a prepayment basis from the defendant, and some courts held that he could recover the contingent fee. These holdings created a bonanza for plaintiffs’ lawyers. They profited much more from winning and lost no more from losing than before the legislature enacted the statute. The legislature repealed the statute in 1985. The experience proved nothing except the dangers of enacting poorly thought out legislation.69

The argument to this point has been to abolish the American Rule for all civil cases. The argument for abolishing it in contract cases is even more compelling, because there it operates so unfairly. As a practical matter, it operates only against consumers, because producers can waive its operation against them in the standard contract. For this reason, the courts would be justified in exempting consumers in contract cases from the operation of

the American Rule unless the producer could prove that the consumer had about equal bargaining power, even if the courts did not abolish the rule for all civil cases.

Legislatures have created another reason for comprehensive judicial action in this area. A 1984 study found nearly 2,000 fee-shifting state statutes,70 and legislatures are still enacting them.71 A reporting service, “Attorney Fee Shifting Statutes,” helped lawyers keep track of such statutes from 1977 to 1990.72 The statutes vary widely in the kinds of cases they cover and the conditions and qualifications they set for fee-shifting. Their existence evidences both the popular distaste for the American Rule and the incompetence of legislatures to deal with it. Broad, principled limitations on the American Rule would make these statutes unnecessary.

The U.S. Supreme Court and the U.S. Court of Appeals for the Ninth Circuit have recognized that depriving people of their ability to pay lawyers reasonable compensation can unconstitutionally deprive them of the property rights that lawyers would help them to enforce. In my opinion, these decisions make the American Rule unconstitutional in situations where it effectively deprives people of lawyers by making it uneconomical to pay them. I will treat these decisions in the last chapter.

Damages for Emotional Distress

A plaintiff can now recover damages for emotional distress in almost any jurisdiction if the defendant committed a bad faith breach or a relational tort. Traditional law already entitles a plaintiff to recover such damages for ordinary breach of contract if the contract is “of a personal nature” or if the conduct that breached the contract “included” the commission of a traditional tort. Since the 1970s courts have also increasingly allowed plaintiffs to recover damages for emotional distress even if the defendant committed only an ordinary breach, on condition that the party’s emotional distress was a reasonably foreseeable result of a breach when the parties made the contract. As of the mid-1990s, there were decisions in nineteen jurisdictions so holding.73 This condition is simply the foreseeability rule, which limits a contract plaintiff’s entitlement to any kind of damages. Thus, the trend has been to eliminate the special limitations that have traditionally applied to emotional distress damages and treat them like damages of any other kind.74

However, a plaintiff who can ground a claim in tort still gains certain advantages. The tort foreseeability rule is considerably broader. A plaintiff who was unusually susceptible to emotional distress might recover in tort although he could not have recovered in contract, for example. The time at