University of Arkansas System
Type of paper: Thesis/Dissertation Chapter
Breach of contract – contract law
Spanish Contract Law provides a broad notion of breach of contract for any behavior that departs from the specified behavior in the contract in any way (time, quality, substance, etc.) or is not specially justified on legal grounds (actions forbidden by the government are not breaches since they are justified on a legal ground).
The general benchmark to determine breach is the contract agreed by the parties themselves, and not external notions. However, external notions are used in important situation such as the consumer’s market where the consumer’s expectations are the primary benchmarks to assess quality and performance since there is not an explicit contract. External notions are also important in other market, where a third party may have some duty or responsibility over the contract, and therefore, is responsible (at least in part) for any potential breach.
The reason for breach does not exclude the breach. What matters is the breach. The analysis of breach takes place in objective terms. Subjective factors generally do not exclude breach, although they may affect remedies. In certain contractual areas, breach of duty and fault are generally required (professional contracts, management contracts: breach requires violation of a duty of care or a duty of loyalty). In professional contracts, the fault may be of a professional who was in contract with the firm, and in management contracts, it may be the fault of the manager.
Spanish Contract Law provides a wide range of general remedies for breach of contract: • Specific performance: the court forces the breacher to act as it was established in the contract. If for example, the contract stipulated that the promiser had to give the promisee a product of quality 2 and he delivers a good of quality 1, then as remedy the court force the promiser to deliver a good of quality 2.
• Damages: the court force the breacher to pay a certain amount of money (damages) to the other party as compensation. It is a monetary remedy. The court calculate the amount to be paid.
• Liquidated damages: these are also monetary compensation, but with the difference that they are not calculated by the court, but they are instead specified in the contract itself. One example are the soccer players’ contracts, or sale contracts that specifies the amount to be paid for each day of delay.
Other general remedies that we can find are:
• Termination: if a party suffers a breach, it can contract with another party and abandon its contractual obligation. If the breacher does not agree with this, court is necessary.
• Reduction of prices: in case of breach of a party, a general remedy is to reduce the price to equilibrate the contract.
Generally, it is the aggrieved party who chooses the remedy to be imposed.
3) Specific performance:
Specific performance is a remedy for breach characterized by the fact that a failed performance or departure from required action by the contract will be imposed upon breaching party. It is also characterized by several material variants of the remedy such as: forced delivery, forced action, injunction not to do, repair defective performance and replace non-conforming good. In the case of the injunction not to do, the court oblige the breacher not to do something, such as obliging a CEO to work for the competition if in the contract it was stipulated that he cannot. Specific performance conceptually includes repair and replacement of consumer goods.
The main issue with specific performance, when it is feasible, is the issue of the balance of benefits and costs of the remedy. Specific performance implies that the breacher perform as the contract establishes. However, sometimes, the cost of this performance may be higher than the benefit in social welfare terms. Take the example of the mining firm, which has a contract with the owner of the land to mine for 10 years and then clean the land. When the 10 year pass, the firms breaches the contract and refuse to clean. The cost of cleaning the land is 20 millions, and the benefit for the owner is 1 million. So if the court imposes a specific performance to firm, society will loose 19 millions. A good alternative would be to impose damages to the firm, which would be preferred by the owner, since an agreement between the firm and the owner will be reached that maximize the social welfare.
In these cases, performance may be more costly than its value for promisee: performance may be ex post inefficient.
There are both positive and negative features of specific performance as a remedy. As positive features, we can distinguish low informational requirements to apply remedy (avoids cost of error linked to estimating damages) and the party aggrieved by breach appears to be satisfied in its promissory expectation. As negative features, we find performance may be more costly than its value for promisee (performance may be ex post inefficient), requires a court order and takes time, for complex performances requires costly and difficult supervision by court and performance by a party forced to comply with contract may be perfunctory (lowest effort) at best.
Damages are understood as general remedies that can be applied to all types of contracts and breaches of contracts. It is a remedy defined in very broad terms: amount of money to compensate any harm suffered by the injured party as a consequence of any breach of contract. We can differentiate between two kinds of damages: expectation and reliance damages. This is why it is a remedy with a variable extension.
Expectation damages is the sum of money that will give the party damaged the same amount of welfare and utility than if the contract would not have been breached and the final result would have been attained. Therefore, the breach party would have to pay the aggrieved party an amount of money that would compensate for the harm caused and in addition an amount of money equal to the value of the performance for this party.
There are however some problems with expectation damages since they are difficult to compute and some instances of moral hazard may appear. Those who seek for damages have to provide evidence of both the existence and amount of damages. This requirement has some exceptions in case of harm in re ipsa: illegitimate use of a productive good, deprivation of a productive good, and few other examples.
Expectation damages is the general rule in Spanish Law for breach of contract. It is the damage measure that accompanies termination for breach and the replacement measure of specific performance. It is awarded when there is a breach of representations and warranties, advertising and promotional communications and in cases of pre-contractual fraud that are equivalent to breach of contracts.
How can we compute expectation damages? When goods or services admit substitutes or cover transactions to avoid the negative consequences of the other party’s breach of contract, the price of these transactions is relevant. If the seller breaches the contract and the buyer has bought a good, generally fungible, then the expectation damages will be equal to the difference between the price of the substitute and the price established in the contract: Psub-Pc. If the buyer breaches the contract and the seller celebrates a cover sale the expectation damages would be equal to the difference between the price established in the contract and the price of the new sale: Pc-Psub. Other ways of computing expectation damages are the following:
Market damages: (for fungible good with market price) buyer will receive expectation damages consisting of the difference between the market price when the breach of contract took place (Pm) and the contract price (Pc). Seller will receive the opposite difference.
Expectation damages present some limitations that reduce it scope and amount. One of this limitations is the foreseeability rule. This rule state that the breacher should only be liable for the things that are foreseen or could have foreseen at the time of contracting and that are necessary consequence of his failure to perform. For instance, if the foreseeable harm of a breach is 100 and the aggrieved party end up suffering a loss of 1000, the foreseeability rule states that damages will amount only to 100. The foreseeability rule gives incentives to give information in the time of contracting. Those who suffer from harm must declare the value of the performance. In tort law, there is no foreseeability rule, you pay the actual damage. Another limitation is the duty to mitigate damages: the aggrieved party is under the duty to mitigate damages that the other contracting party has caused with her / his breach of contract.
Reliance damages: sum of money that will give the party damaged the same amount of welfare and utility than if the contract would not have taken place (the initial situation). This is why reliance damages are generally lower than expectation damages. Reliance damages cover expenses for the injured party derived from concluding the contract, specific investments that the injured party has made in reliance of performance of the contract by the other party and opportunity costs. Limited assets:
Damages do not always work well. Sometimes, individuals can bear the payment of these damages, and therefore, they will have incentives to reduce them. However, this is not always the case. When the breacher has not enough assets to pay damages up to the point of optimal care, damages do not work well, because people will not pay for the consequences of their acts, and therefore, their level of care will be the optimal according to what they can pay, and not what they should pay. This is known as judgement proof problem.
Damages for pain and suffering:
The traditional position of the Spanish Supreme Court and Spanish Courts is:
• To accept damages for pain and suffering for breach of contract
• To award damages for pain and suffering with a relative amplitude and generosity.
• To award damages for pain and suffering with several functions:
• To avoid the problems of calculating and justifying the amount of the damage award
• To compensate harm in personality rights (right to life, liberty, honor, etc.).
• To compensate non-patrimonial values joined to economic goods and rights (discomfort, inconvenience, disappointment, frustration)
• To punish intolerable or egregious behaviors of breach of contract. When an individual suffer harm, her utility decreases (she goes form point A to point B, but her utility function for money will not change). If this harm is economic, we can compensate this harm with money, which will leave her at point A again. However, the harm that an individual can suffer may be non-economic, and for the same amount of money her utility decreases (her utility function changes). Money cannot restore the initial utility (a huge amount would be needed). This is the case of pain and suffering (accident and death of a relative, discomfort, etc). This is why it is useless to take insurance for death, since it would not compensate the harm. The hairy hand example:
What is the difference between expectation and reliance damage? Let’s look at an example. An individual was injured in his hand and lost 50% of his use. He entered in a contract with a doctor who promised to reestablish the hand to a 100% of use in exchange for quantity of money. Before the contract was made, the individual was situated in an indifference curve that related all the combination of hand use and money that let the individual indifferent. We assume that the individual is willing to give up hand use for money. After the contract and operation, the individual was worse off, with 25% of use. What should the doctor pay as damage? If expectation damages are used, the doctor should pay the individual a quantity of money that together with the 25% of hand use leave him with the same utiity as if the contract had succeded and he had 100% of use (situate him in a higher indifference curve). If reliance damages are imposed, the doctor should pay the individual a quantity of money that, together with the 25% of hand use, leave him with the same utility as if the contract did not take place, with 50% of hand use (situate him in the initial indifference curve).
5) Liquidated damages:
Liquidated damages are damages for breach that are not determined ex post breach by a Court or arbitration panel, but ex ante by the contract parties themselves into the contract. Such possibility of “privately stipulated” remedies for breach is acknowledged by most legal systems, typically in the form of payment of money, although other possibilities may exist. They typically replace Court damages and they can be agreed as added penalty for breach.
The most important issue is whether Courts are forced to enforce liquidated damages, or they may disregard, or reduce, the amount of the liquidated damages award. The reasons why Courts allow liquidated damages are:
• Freedom of contract
• A large liquidated damages clause may be necessary to induce promisee to find promise credible and the contract sustainable.
• Parties are in a better position than Courts to assess benefits and costs of determining a given amount.
• Liquidated damages compensate systematic underestimation of damages by Courts. If liquidated damages are higher than the expectation damages, then the court will apply the second ones.
There are however some economic arguments that may lead to reduce or at least control the level of liquidated damages clauses:
• “Excessive” damages clauses resulting from incorrect predictions or forecasts about future outcomes.
• External shocks unforeseen by parties that produce an unexpected increase in the damages payment.
• True “uncertainty” about future costs for one party.
• Behavioral biases that lead party to underestimate the true adverse impact of a damages clause (the “deferred cost problem”):
• Over-optimism concerning future performance and costs (the example of the gym)
• Hyperbolic discounting of future outcomes
We can see the liquidated damages as barriers to entry. An excessive amount of LD is beneficial for the parties to the detriment of a third party who may bid for the services of breaching party. Promisor agrees to pay an amount larger than ED, in exchange of higher price. Promisee uses high liquidated damages to extract larger payment from a third party interested in performance by promisor: larger payment from third party increases the surplus to the contract parties, that is shared between them. Also, excessive payment of third party are made possible by excessive damages clauses, which reduce efficient entry by third parties, and prevents them from successfully bidding for promisor’s performance. That is why the goal of reducing “excessive” liquidated damages is not to protect the breaching party, but third-parties.
Sometimes, excessive LD for signaling are unwanted, since an unforeseeable contingency may appear that will cause a breach in the contract. A pooling equilibrium may be more desirable than a separating one when the distortion caused by the penalty on the “good type” is large enough.
Among the general remedies for breach, the last one is termination (or rescission, or cancellation, as it may also be called in Common Law jurisdictions). This remedy entitles the aggrieved party to cancel the contractual relationship with the breaching party, eliminating the obligations arising from the terminated contract.
Once the contract is terminated the parties should give back what was received under the contract, unless the goods are now in lawful possession of a third party. In this case, the value of the goods would replace the goods themselves. The elimination of the effects of the contract is retroactive: it is considered that the contract did not exist.
Spanish courts have established that termination does not require a lawsuit. However, if the other party disputes the termination or its conditions, restitution would require a lawsuit. Courts do not determine termination, but declare whether termination was or not properly effected by the party. The most contested issue about termination is when is termination available as a remedy. It is clear that not every breach or non-performance allows the aggrieved party to terminate, but a qualified breach (material or fundamental breach) is required. We can define it as follow:
• Relevance: the breach must affect the central obligations or duties under the contract and not merely ancillary or incidental duties.
• Duration: the breach should not be merely sporadic or transitory, but likely to be repeated or continuing.
• Importance: the breach must substantially affect the interests of the non-defaulting party. Termination does not go alone, it does not exclude damages, and in fact it is naturally accompanied by damages payment.