From an economic point of view, the primary problem is therefore identifying a legal rule that would create incentives for optimal reliance, avoiding both under-investment (inefficient because it prevents the maximisation of the total surplus obtainable from the transaction) and over-investment (inefficient because it leads to a waste of resources when negotiations are unsuccessful). The problem is complicated by the necessity to optimise simultaneously the reliance incentives for both parties. In fact, although legal scholars and earlier law and economics scholars generally believed that the under-investment problem, created by the traditional common law rule of no liability, existed only when just one party relies, later analysis shows that under-investment can still occur even if both parties rely on the successful formation of the contract (and make ‘relation-specific investments’ based on that reliance).6

As critics of precontractual liability have pointed out, moreover, the imposition of some kind of precontractual liability may deter parties from entering negotiations in the first place. Potential liability may increase transaction costs and discourage people from negotiating, even when the transaction, if successful, would have created a positive surplus.7

In the subsequent sections of this chapter, we briefly discuss the solutions proposed by the law and economics literature. We then try to apply these solutions to some of the hypothetical cases used in this study to verify how those cases should have been solved according to the results of law and economics analysis.

Law and economics models of precontractual liability

Legal solutions to the precontractual liability problem are quite diverse. Solutions range from the absence of a general principle of precontractual liability (which is the dominant position in common law jurisdictions)8 to the acceptance of very strict rules imposing liability on the retreating party in most every case (such as the Dutch ‘third-stage’ rule, which holds the retreating party liable if negotiations are broken off in an advanced stage and imposes liability for expectation damages or

6For an explanation of this point, see below text to n. 21.

7See Farnsworth, above n. 1, pp. 221, 243.

8See the Editors’ Conclusions, below pp. 449ff. and the particular discussion of English law at pp. 461–8.

434 precontractual liability in european private law

even specific performance of the contract).9 In between these two extremes are those jurisdictions that recognise a general duty to negotiate in good faith, imposing on the retreating party liability for the claimant’s reliance damages (that is, liability limited to reasonable expenditures made relying on the prospective contract).

The so-called ‘law and economics methodology’ developed primarily in common law jurisdictions. Until recent years, the vast majority of law and economics scholars were trained in these jurisdictions. This influenced the approach followed by law and economics scholars on a number of legal issues, including precontractual liability. This influence is evident in two main ways. First, since common law is generally reluctant to impose liability on negotiating parties prior to the formation of a contract, the problems related to precontractual liability have been largely neglected in the economic analysis literature. Secondly, the existing law and economics literature on precontractual liability focuses essentially on the economic analysis of legal doctrines (such as the ‘promissory estoppel’ doctrine)10 developed in common law jurisdictions and applied by common law courts to impose liability for precontractual conduct in some circumstances. Because of this narrow focus, little attention has been devoted to the economic analysis of broader general principles of precontractual liability, such as the general duty to negotiate in good faith and the concept of culpa in contrahendo followed by a number of civil law jurisdictions.11 Nevertheless, the results of the existing studies provide a useful framework for analysing the problems related to precontractual liability from an economic perspective.

The first economic analysis of precontractual liability evaluated the efficiency of judicial doctrines that departed from the general rule of no liability, imposing liability on the retreating party before the formation of the contract when certain conditions were met. These judicial doctrines drew a new line between no liability and liability by distinguishing between mere negotiations and commitment. Frequently, these analyses linked liability to the existence of an implied ‘promise’ that could be drawn from the parties’ conduct during negotiations.

9See the Dutch report on case 1, above p. 46, and the discussion of Dutch law in the Editors’ Conclusions, below pp. 468–70.

10See the English report on cases 2 and 8, above pp. 68 and 236, but note the discussion there to the effect that the scope of the promissory estoppel doctrine varies amongst the different common law jurisdictions.

11See generally the Editors’ Conclusions, below pp. 452–6.

436 precontractual liability in european private law

hypothetical contracting could serve as a useful benchmark for the analysis of precontractual liability. Some limitations of this approach should be noted, however.

As pointed out above, reliance investments potentially increase the value of the contract. Each party wishes to appropriate the surplus created by such investment. It is thus in the interest of parties who undertake the reliance investment to conceal their reliance, to protect the surplus from the appropriation efforts of the other party. This leads to a problematic circularity. To avoid potential lack of co-ordination between the parties’ levels of commitment and reliance, Craswell’s hypothetical-contract rationale for precontractual liability requires some correction, ensuring that reliance investments be disclosed to, or otherwise observable by, the other party.

Katz’s model: the efficiency of ‘promissory estoppel’

Professor Katz reaches a different solution. He considers specifically the doctrine of promissory estoppel, used by courts to bind a party to promises made during negotiations in order to find such party liable towards the relying party.15 Katz investigates the conditions under which this rule can be deemed to be more efficient than the traditional common law rule of no liability. An important assumption of Katz’s model is that neither judges nor juries are in the position to make a substantive determination regarding optimal reliance, which is the ultimate goal of an efficient legal rule.16 Accordingly, the Learned Hand test is inapplicable (as is any rule that conditions liability on the ability of a court to find an efficient level of reliance).

For Katz, the rule for precontractual liability should assign liability based on Calabresi’s concept of ‘least-cost-avoider’. The least-cost- avoider, in Katz’s view, is usually the party with the greater bargaining

15See Restatement (Second) of Contracts § 90 (1979): ‘A promise which the promisor should reasonably expect to induce action or forbearance on the part of the promisee or a third person and which does induce such action or forbearance is binding if injustice can be avoided only by enforcement of the promise. The remedy granted for breach may be limited as justice requires.’

See also G.B. Buechler Jr., ‘The Recognition of Preliminary Agreements in Negotiated Corporate Acquisitions: an Empirical Analysis of the Disagreement Process’ (1989) 22 Creighton Law Review 573, 574 (pointing out the difficulty for parties to reasonably predict court decisions on the basis of such doctrines); R.E. Scott, ‘Hoffman v. Red Owl Stores and the Myth of Precontractual Reliance’ (2007) 68 Ohio State Law Journal 1 (arguing that precontractual liability in the United States does not exist beyond the narrow case of enforcement of preliminary agreements).

16Katz, above n. 5, pp. 1272–3.

power ex post (the party who has the power to modify the initial terms once reliance investments have occurred).17 If the non-relying party has the greater bargaining power ex post, that party should be bound by preliminary promises, in order to prevent opportunistic behaviour (e.g., raising the price after the other party has made reliance investments). Conversely, if the relying party has the greater bargaining power ex post, the traditional common law rule of no liability should apply, inasmuch as the opportunistic behaviour of the non-relying party is likely to be constrained by the stronger bargaining power of the relying party.18

Bebchuk and Ben-Shahar’s model: searching for an efficient ‘intermediate’ rule

The solutions discussed above show powerful intuitions. However, their scope is somewhat limited. Being rooted in traditional contract theory, they try to determine when a party should be bound by preliminary manifestations of intent, establishing a stark line when contractual liability should begin. This approach leads to a dichotomy: the parties’ precontractual exchanges are either fully binding or have no legal consequences. Precontractual liability can avoid this dichotomy, however, finding its fundament on other grounds.

One of the most recent and most complete works on precontractual liability is a paper by Bebchuk and Ben-Shahar.19 Their analysis differs in several respects from those in the previous section.

First, the authors point out that the reliance problem is often bilateral: each party relies on the other’s promises during negotiations and invests accordingly. Bebchuk and Ben-Shahar address this problem in their paper, expressly introducing bilateral reliance in their model.

Secondly, the authors move away from the previous all-or-nothing approaches to precontractual liability, noting that the efforts to determine a clear point where non-binding negotiations should end and precontractual liability should begin are generally misguided. The major focus of their analysis is on ‘intermediate’ liability rules that allow partial liability if a party does not fulfil precontractual promises and the parties do not enter into a contract.

17 Ibid. p. 1273. 18 Ibid. p. 1277.

19L.A. Bebchuk and O. Ben-Shahar, ‘Precontractual Reliance’ (2001) 20 Journal of Legal Studies 423.

438 precontractual liability in european private law

Thirdly, Bebchuk and Ben-Shahar explicitly analyse the impact of precontractual liability rules on the parties’ incentives to participate in negotiations in the first place.

As for standard tort law analysis, they begin by considering the two polar regimes of no liability and strict liability. Predictably, under a regime of no liability (like the traditional common law rule) each party will under-invest in reliance20 because the rule does not allow parties to fully internalise the benefit of investment. Conversely, under a regime of strict liability (defined by the authors as a rule which requires each party to fully compensate the other party for reliance investments if the parties do not enter into a contract), each party will over-invest because the cost of reliance is shifted to the other party.21

After assessing these results, the authors explore three different possibilities for intermediate liability rules that could potentially produce optimal reliance decisions.

Rule 1: the first proposed rule imposes full liability for precontractual reliance on a party that bargains in an ex post opportunistic manner (i.e., by demanding a price that, taking into account the other party’s reliance expenditures, would leave the other party with an overall loss from the transaction).22 Under this regime, both parties make optimal investments because neither can totally shift the costs to the other, but must bear a fraction of the total cost that is equal to the fraction of the incremental surplus that party will extract from the investment.

Rule 2: the second proposed rule is a cost-sharing rule: each party bears part of the total reliance cost (that is, pays for part of the other

20Ibid. pp. 431–2. Intuitively, it may seem that when both parties invest in reliance, the problem of under-investment would diminish substantially. In fact, what causes under-investment is the risk that the other party will walk away from the negotiations. But if both parties rely, neither would want to walk away because both have something to lose (the precontractual investment that is wasted if the contract is not formed). However, Bebchuk and Ben-Shahar show that this common assumption is incorrect: under-investment is more related to the existence of a surplus from the transaction than with the risk of negotiation breakdown. The surplus depends on the investment of both parties. When the parties’ investments are ‘strategic substitutes’ (the investment of one party reduces the marginal value of the other party’s investment), one party will invest less when the other party also invests than when the other party invests nothing. Conversely, when the parties’ investments are ‘strategic complements’ (the investment of one party increases the marginal value of the other party’s investment), one party will invest more when the other party also invests. Finally, when the parties’ investments are independent, the investment of one party does not depend on whether or how much the other party invests.

21Ibid. pp. 433–4. 22 Ibid. pp. 435–7.