05 May 2014

Against Freedom of Contract

American law affords people great freedom to determine the nature of their legal liabilities to each other by entering into contracts.  Indeed, it very nearly approaches an ideal that is not just libertarian, but anarchist, despite the fact that neither of these political ideologies had wide political support in the general public.

Contracts can alter the extent to which liability is imposed as a consequence of negligent acts that caused injuries and can change the measure of damages that will be imposed upon them in the event of a breach of a legal duty or modify statutes of limitations to enforce rights.  They can determine whether or not a party will be entitled to attorneys' fees in the event of a dispute that is litigated.  They can eliminate a right to punitive damages, despite the fact that such damages can only be imposed in cases of the kind of misconduct for which liability itself cannot be waived as a matter of public policy.  Promissory notes routinely impose higher interest rates for the time value of money when the notes are in default than when they are not, and very little law limits the size of the penalty rate imposed after a default.  The parties to a contract can also agree to a great variety of matters concerning the manner in which disputes between the parties will be resolved - waiving a right to a civil jury trial, waiving access to the federal courts, waive a right to pursue a claim as part of a class in a class action, authorizing someone not involved in the underlying transaction to bring suit based upon it, or even waiving access to the court system entirely in lieu of only minimally regulated arbitration systems.

General Mills would like to impose an arbitration agreement on anyone who likes their Facebook page in the event of a lawsuit arising from a purchase of Cheerios or Chex.  Home inspectors routinely try to insist that a lawsuit against them for any harm suffered by their failure to do their job properly is limited to a refund of their fee and that even that remedy can be secured only in arbitration.

Freedom of contract is not absolute.  Statutes and public policy considerations impose certain limitations.  They generally prohibit waivers of liability for intentional misconduct, willful and wanton misconduct and gross negligence.  They prohibit liquidated damages clauses in circumstances when actual damages are easily determined or when the penalty is grossly disproportionate to a difficult to quantify harm.  They must afford some means of resort to a third party for dispute resolution or contract enforcement that meets certain minimum standards.  Interest rates cannot exceed rates defined as constituting usury.  Consumer defendants cannot be bound to respond to debt collection lawsuits in geographically distant venues.  Outside highly regulated sports and medical contexts, one cannot consent to not sue someone for intentionally causing you physical harm, for example, in the context of a duel.  Contractual limits on the grounds upon which a married couple may obtain a divorce are generally void, as are agreements in advance concerning post-separation or post-divorce parental responsibilities or child support payments, although there are only modest limitations on contractual agreements regarding property division and maintenance upon a divorce.

Closely akin to the issue of freedom of contract is the impact of disclosure on legal liability.  Products liability law is unduly focused on failure to warn, rather than on the merits of whether a product is dangerous or defective.  Medical malpractice litigation tends to focus on whether a patient was told that something really bad could happen even in the absence of negligence, rather than on whether the physician took appropriate steps to reduce the likelihood that those bad outcomes would actually occur. Securities fraud law permits firms to avoid liability by formally warning investors of risks that all of the other conduct of the sellers pushes buyers to ignore.

As an attorney, it is my stock in trade to draft contracts that do all of these things, and to litigate in light of these terms when they exist.

But, I am deeply skeptical of the proposition that freedom of contract with regard to the nature and extent of tort liability, or with regard to dispute resolution details and terms, does not do more harm than good.

The firms that are sophisticated enough to systemically enter into contracts that minimize their legal liability are often the very same firms that would be in the best position to take the necessary care to prevent negligent harms from occurring in the first place and to refrain from taking actions that would breach their contracts.

Provisions that inflate remedies for contractual defaults, like late fees and high default interest rates, usually have the practical effect of unfairly preferring those contractual debts vis-a-vis third parties who did not agree to that contract who have debts for the same principle and non-default interest amount in bankruptcy, rather than influencing how much is paid by the defaulting party to the contract who often can't pay the principal amount of the debt and non-default interest, let alone the late fees and default interest amounts that are owed.

The overwhelming majority of cases in which there is an arbitration clause is one in which the clause was included to discourage the non-drafting party from asserting that party's substantive rights in the event of a breach of contract or tort, or to otherwise provide an inferior forum to that party to obtain a fair remedy for wrongdoing by the drafting party, rather than out of any legitimate concerns regarding privacy, litigation costs, delay or a potentially unfair public court forum.

It is not at all obvious to me that our economy would be less healthy, or less efficient, if all contractual agreements provisions regarding tort liability, damages in the event of breach of contract or tort, or dispute resolution process were per se void as a matter of public policy.

An immense amount of dead weight loss transaction costs in our economy is devoted to paying people like me to game the system, that would be better spent on funding insurance purchases and reserves for contract liabilities when torts and breaches of contract inevitably happen.  The notion that securing express consent to contractual terms via shrink wrap agreements, liability waivers, terms of service, and the other pervasive contracts of adhesion that fill our lives is dubious at best and often outright absurd.

For example, even if it makes sense to hold swimming instructors liable only for willful and wanton misconduct, gross negligence or intentional conduct, rather than for mere negligence, there is no reason at all to believe that doing so on a transaction by transaction basis with non-negotiable liability waiver contracts signed by parents on behalf of their children is a more efficient way to address this issue than it is to address it with a generally applicable statute concerning swimming instructor liability or common law rule applicable to that situation.  Hundreds of thousands of dollars of liability for a personal injury sustained by a child learning to swim in connection with that student's instruction, should not primarily depend upon whether or not the administrative employee in the front office remembered to have that student's parent sign a form or not.  The amount of legal and administrative expense that goes into the process of preparing, executing, and maintaining records of those waivers of liability for negligence is not insubstantial and is wildly inefficient.

Of course, these terms are also found in vigorously negotiated, individualized contracts involving sophisticated commercial firms that are bargaining at arms length.  There is often no question in those cases that there has been the kind of meaningful and knowing consent to these terms that the legal theory of contract law contemplates when it justifies its freedom of contract principles.  But, even in these circumstances, the desirability of this freedom is questionable.

The transaction costs involved in this part of the negotiations relative to the stakes involved in the transaction are often much higher than the transaction costs involved in consumer contracts of adhesion.  The negotiation process over these terms inevitably prevents a not insignificant percentage of large scale economically valuable deals that would otherwise have been entered into from being concluded.  The way that issues addressed by these provisions are resolved when contracts contain provisions that differ greatly from the default rules of law are present are often unfair and create systemic incentives for misconduct by the party whom the negotiated contracts tend to favor (the notion that parties to a contract are economic equals is almost never true).  And, there is virtually no meaningful empirical evidence to show that business would not be capable of proceeding efficiently and productively in the absence of a decent set of universally applicable default rules.

Of course, to the extent that we have bad default rules of law, an inability of private parties to negotiate around them encourages legislators to fix the problems, which benefits not just those who would otherwise have put the changed new rules that apply in absence of an agreement into their contracts, but only benefits those who weren't savvy enough to draft contracts with better rules regarding how disputes regarding breaches of contact are resolved both in terms of process and substance.

Of course, given the race to the bottom federalism considerations involved, implementing such policies would require federal law intervention under the commerce clause power and/or bankruptcy power of Congress to be viable to implement without creating intense choice of law problems.

What would the rules look like?

* The prevailing party in disputes involving express contracts would have a right to recover their attorneys' fees and costs (something that is already a default rule as a matter of law in the case of leases in Colorado).

* Default interest rates in excess of the non-default rate would either be prohibited as a penalty against public policy.  An intermediate position would be to subordinate those debts in bankruptcy to all other debts, but that would still disadvantage third party creditors to the extent of pre-petition payments of default interest that reduce the size of the pie.  Another intermediate position would be to impose a certain interest rate in addition to the contract rate, for example, four percentage points per annum or the prime rate, in addition to the contract rate in the event a default.  Thus, the default interest rate on a contract with no stated interest rate would be 4%, while the default interest rate on a contract with a 5% stated interest rate would have a default interests rate of 9%.  If all creditors got the same default interest rate relative to the non-default status quo, in and out of bankruptcy, the prejudice to third party creditors would be eliminated.

* Late fees might be capped at a one time fee of 5% of the payment then due and would not apply to accelerated balances until their non-default due date.

* A variety of boilerplate terms might be implied as a matter of law into certain kinds of written agreements unless otherwise provided, e.g. regarding contract interpretation, definitions, etc.  Colorado does this already, for example, in the case of powers of attorney and other grants of fiduciary powers.

* The right to a civil jury might be eliminated in most breach of contract claims based upon written contracts that do not involve allegations of fraud.  (There is already rarely a right to a trial by jury for fact and credibility intensive rescission claims.) Common law already makes contract interpretation a matter of law in most cases, and breach is generally well defined in such cases, so the main shift would be in giving judges the more authority to determine contract damages.  Contract claims already make up only about 25% of civil jury trials despite the fact that the number of written contract claims litigated vastly outnumbers the number of personal injury tort claims litigated on court dockets.

* Statutory law would draw clearer lines regarding the measure of damages in a variety of particular industry contexts such as defective software, inaccurate home inspections, etc.

* The circumstances under which arbitration clauses would be permitted would be greatly narrowed, the conduct that could submit someone to an arbitration agreement would be greatly formalized along the lines of recent uniform legislation on marital agreements, and the occupational activity of arbitrating disputes would be much more heavily regulated to insure neutrality and fairness in the process.

* Waivers of liability for negligence would be void as against public policy, but a set of statutes would outline circumstances where there would not be liability for negligence (e.g. volunteer emergency assistance and inherently dangerous activities).

* Punitive damages waivers would be prohibited.  But, punitive damages and statutory damages ought to be subordinate to all other claims in a bankruptcy, or in the event of a dispute between judgment creditors over the same income or assets in bankruptcy.

* In some cases, like medical malpractice, a negligence based tort process could be replaced by a no fault regime of strict liability for bad outcomes with strictly compensatory damages and mandatory insurance to cover that liability, rather than a fault based regime that covers non-economic damages, with exceptions of willful and wanton or reckless or intentional misconduct, and with automatic referrals for disciplinary action on a license in cases of gross negligence.

* Contractual terms giving rise to a default in the absence of a breach of the substantive obligations of the parties to perform the contract ought to be disfavored.

* Failure to warn liability ought to be reformed, both to make unreasonable or unlikely to be read warnings ineffective particularly if rebutted by other communications or advertising, and to make warnings of obvious dangers unnecessary.

* Some minimum substantive securities regulation standards ought to be imposed, so that certain kinds of offerings are prohibited even if investors are warned about the risks in question.  Alternatively, a doctrine that subordinates formal written disclosures to other communications with investors might apply.

* In part to discourage venue shopping and in part out of the federalism notion of subsidiarity, I would favor the elimination of federal court jurisdiction in all ordinary diversity cases involving U.S. citizens (for diversity of citizenship jurisdiction purposes) (currently allowed when the amount in controversy exceeds $75,000 and the parties are diverse in state citizenship) and in all federal question cases involving private parties who are U.S. citizens (for diversity of citizenship jurisdiction purposes) (currently allowed in all cases with a federal question).  Thus, almost all employment litigation involving private parties (now federal question litigation), almost all contract disputes involving private parties, and almost all personal injury cases involving private parties would be limited to the state courts.  Cases with international diversity of citizenship (e.g. between a non-U.S. company and a U.S. company), special diversity of citizenship cases (e.g. multi-state class actions, and interstate interpleader cases), and special federal question cases that don't come under the general federal question statute (e.g. intellectual property and civil rights cases), as well as cases involve the U.S. government as a party, would remain in federal court.

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