Efficient Breach – Not a Moral or Ethical Obligation

November 23, 2011

Recently, I was listening to NPR and to Carl Richards, a financial adviser, telling his story regarding how he stopped making his mortgage payments. Given the current economic times, this is not a unique story. I was particularly struck by his remarks repeated here in the New York Times:

At first, I dismissed the idea of a short sale. Late that summer, I sat down with a really close friend in Las Vegas, someone I looked up to. He cut to the heart of the matter right away: Why, he wanted to know, were we still making the payments?

Because I have a moral obligation, I said. You pay your debts.

He proceeded to explain that I didn’t have a moral obligation to the bank. I had a moral obligation to my family. I had a contractual obligation to the bank, along with a clear moral obligation to be honest in my dealings. What he was asking was this: Which is more important? Your contractual obligation to the bank or your obligation to your family to preserve your ability to make a living?

His statement got me thinking of two separate issues – One, does the law impose a moral or ethical obligation for the continued performance of obligations under a contract or can we breach them intentionally without incurring punitive liability? Second, and perhaps an even more interesting question for attorneys:  does a corporate attorney or in-house counsel, given that a corporation’s underlying goal is maximizing shareholder value, have an affirmative ethical obligation to advise his/her corporate clients to intentionally breach a contract when it is economically advantageous for the corporation to breach and pay damages rather than continue performance under the contract?

MORAL OBLIGATIONS

In general (of course there are always exceptions) not only is it okay to intentionally breach agreements, but our legal tradition encourages this behavior under the well accepted doctrine of “Efficient Breach”. Under this principle, per Blacks’ Law Dictionary, the efficient breach theory provides, “[t]he view that a party should be allowed to breach a contract and pay damages, if doing so would be more economically efficient than performing under the contract.” I ran a search in the ALLCASES database:

INTENTIONAL! WILLFUL! +2 BREACH! /5 CONTRACT! AGREEMENT /P BAD-FAITH GOOD-FAITH /P MORAL! ETHICAL!

In a Western District of New York case, the Court stated that:

“mortgagor could not recover punitive damages for breach of contract under New York law absent proof of public wrong, moral turpitude or wanton dishonesty…” See, Katz v. Dime Sav. Bank, FSB, 992 F.Supp. 250 (W.D.N.Y., 1997). Another Court in New York held that, “Courts have consistently held punitive damages to be unavailable where the nature of the conduct amounted to nothing more than willful breach of contract, bad faith or simple negligence.”

See, Aniero Concrete Co., Inc. v. New York City Const. Authority, 2000 WL 863208, 30 (S.D.N.Y.,2000).

Another California Court elaborating on policy considerations stated:

“The traditional goal of contract remedies is compensation of the promisee for the loss resulting from the breach, not compulsion of the promisor to perform his promises. Therefore, ‘willful’ breaches have not been distinguished from other breaches … The restrictions on contract remedies serve purposes not found in tort law. They protect the parties’ freedom to bargain over special risks and they promote contract formation by limiting liability to the value of the promise. This encourages efficient breaches, resulting in increased production of goods and services at lower cost to society … Because of these overriding policy considerations, the California Supreme Court has proceeded with caution in carving out exceptions to the traditional contract remedy restrictions.”

See, Freeman & Mills, Inc. v. Belcher Oil Co.11 Cal.4th 85, 98, 900 P.2d 669, 676-677, 44 Cal.Rptr.2d 420, 427 – 428 (Cal.,1995).

Another California Court, citing to an article, stated that:

“One commentator, in lamenting the rather unpersuasive rationales offered by courts, noted that “the unexplained judicial reluctance to impose tort liability upon those who, in bad faith, breach contractual obligations is not only understandable but reflects a perceived awareness of, and faithfulness to, one of the most poorly kept secrets in legal history: Bad faith breach of contract, if defined as an intentional breach motivated by crass economic self-interest, has been, despite a clamoring of moral credos to the contrary, a judicially accepted staple of our system of commercial law…. [A] close scrutiny of commercial law doctrine, and the briefest scrutiny of commercial practice, makes it transparently clear that our system not only sanctions such bad faith breaches, but, with limitations, actually encourages them…. The social policy begins with a recognition that if breaches are too harshly sanctioned, there will be deterrence not only of breach but of the execution of contracts. Therefore, damages must not be so oppressive as to discourage the formation of binding commercial agreements. But far more important is an awareness that intentional breaches of contract often promote the economic efficiency of society. To the extent the promisor’s pecuniary gains from breach exceed the promisee’s pecuniary injuries, the costs of production have been reduced. Were legal liability to exceed the promisee’s pecuniary injuries, an efficient reallocation of resources would be discouraged at societal expense.” (Diamond, The Tort of Bad Faith Breach of Contract: When, If at All, Should It Be Extended Beyond Insurance Transactions? (1981) 64 Marq.L.Rev. 425, 433, 436–437, fns. omitted.)”

See, Rogoff v. Grabowski200 Cal.App.3d 624, 629, 246 Cal.Rptr. 185, 188 (Cal.App. 2 Dist.,1988).

I also ran a search in the ALLCASES database for efficient breach casaes: EFFICIENT /3 BREACH. Looking through some of these cases, it appears that the principle of “Efficient Breach” is well recognized in our legal system and we as a society are indeed okay with intentional breaches of agreements even if they are simply for no reason other than financial benefit to the breaching party. In pure economic terms, “If the net gain to the breacher exceeds the loss to the non-breaching party, the result is efficient, because the world is wealthier.” CONTRACTS-HB § 14.36. But then, what about the tortuous interference with a contract cause of action? A Utah Court framed the issue well by stating:

“We are persuaded by the efficient breach arguments discussed above. When an efficient breach occurs, a breaching party may retain its profits in excess of a plaintiff’s losses as long as the plaintiff is made whole. As was stated in Lake River Corp. v. Carborundum Co., 769 F.2d 1284, 1289 (7th Cir.1985), such a standard is beneficial to both parties because the nonbreaching party receives what it bargained for and the breaching party is able to retain its profits made through its more efficient business practices. In the realm of tortious interference with contract or economic relations, “[i]t would be inconsistent to require the party inducing the breach to disgorge its excess profits while permitting the breaching party to retain its excess profits.” Marcus, Stowell & Beye Gov’t Secs., 797 F.2d at 232.” TruGreen Companies, L.L.C. v. Mower Brothers, Inc. 199 P.3d 929, 935 (Utah,2008)

DUTY to BREACH

So, do corporate attorneys, general-counsels and other attorneys representing corporations have an affirmative duty to advise their corporate clients based on the doctrine of efficient breach to affirmatively breach contracts? The available materials were scant.  But, I did uncover the following:

A recent Delaware Court stated, “corporation’s purpose is to maximize the value of the company’s shares, subject to the constraint that the corporation must meet all its legal obligations…” See, In re Massey Energy Co., 2011 WL 2176479, 20 (Del.Ch.) (Del.Ch.,2011). Given this fundamental purpose for a corporation’s existence, do attorneys have an affirmative duty to advocate efficient breaches of contracts when representing corporate clients? “An attorney has an obligation to act in his or her client’s best interests. It is possible to imagine situations where breaching a settlement may be in the client’s best interests, as when the breach is efficient.” See, Kusters, Civil Liability for Attorneys to Adverse Parties when a Settlement Agreement is Breached in California, 56 Hastings L.J. 1277, 1293 (2005). In another article, the author wrote that, “[t]he court viewed the defense lawyers’ decision to conceal the medical report not as a violation of legal duty to an opposing party, but rather as a tactical or strategic move similar to advising a client in a particular situation concerning “efficient breach”–that breaking a contract in a particular situation would be less costly than performing.” See Camton and Knowles, Professional Secrecy and its Exceptions: Spaulding v. Zimmerman Revisited, 83 Minn. L. Rev. 63, 75 (1998).