Dividing the Surplus upon Termination: The Case of Relational Contracts
2011; Wiley; Volume: 48; Issue: 1 Linguagem: Inglês
10.1111/j.1744-1714.2010.01110.x
ISSN1744-1714
Autores Tópico(s)Legal principles and applications
ResumoRelational contracts1 1Throughout the article, I will assume that the term “relational contracts” refers to long-term contracts that aim to ensure cooperation between the parties, and not merely an exchange of goods and risks between them. Cf. Melvin Eisenberg, Relational Contracts, in Good Faith and Fault in Contract Law 291, 291–96 (Jack Beatson & Daniel Friedmann eds., 1994) (discussing possible definitions of “relational contract”). typically create value that survives the end of the contractual relationship. Married couples accumulate matrimonial property that remains valuable long after they cease to value each other. Employees perform tasks that still benefit their employers long after they move to another workplace. Agents and distributors develop the markets for the products they distribute, thus creating goodwill that will outlast their commercial relationships with the manufacturers. In all such cases, a similar question arises: how to divide the value that survives after the contractual relationships are dissolved. Consider the following hypothetical.2 2The hypothetical is loosely modeled after the Israeli case CA 442/85 Zohar v. Travenol Labs [1990] IsrSC 44(3) PD 661. AAA Labs, a large medical equipment producer located in Europe, decides to enter the U.S. market. After researching different venues to achieve its target, AAA Labs contacts a respected American physician, Dr. T, with an offer to serve as its U.S. distributor. Dr. T agrees, and the parties enter into a commercial agency agreement that is indefinite in duration. In the following years, Dr. T invests all of her abilities and charm into marketing AAA Labs' products to American health service providers. Dr. T is very successful, and she achieves an excellent penetration rate into the American market. However, after seven years of collaboration with Dr. T, AAA Labs makes a reassessment of its worldwide distribution strategy and decides to establish subsidiaries in all of its destination markets, including the United States. Consequently, AAA Labs notifies Dr. T that, regrettably, it must terminate their agreement. Assuming that AAA Labs' decision to reorganize its marketing operation is a legitimate one, how should the law account for the value that survives after the end of the beneficial commercial relationship between AAA Labs and Dr. T? Does this value, namely the American goodwill of AAA Labs products, belong to Dr. T, to AAA Labs, or is it to be divided between them? Need one of them compensate the other for gaining this surviving surplus? Questions of allocation such as these, when they arise in the context of relational contracts, are the subject of this article. Apparently, the question of allocating the surplus upon termination is common to all forms of contracts, discrete and relational alike.3 3The distinction between relational and discrete contracts is one of the most fundamental distinctions in modern contract law. Ian Macneil is the most prominent contributor to the development of this distinction. See generally Ian Macneil, The New Social Contract: An Inquiry into Modern Contractual Relations (1980); Ian Macneil, The Relational Theory of Contract: Selected Works of Ian Macneil (David Campbell ed., 2001); Macneil, Ian, The Many Futures of Contracts, 47 S. Cal. L. Rev. 691 (1974). Other notable contributors include Charles Geotz, Robert Scott, Robert Gordon, and Stewart Macaulay. See generally Goetz, Charles & Scott, Robert, Principles of Relational Contracts, 67 Va. L. Rev. 1089 (1981); Gordon, Robert, Macaulay, Macneil, and the Discovery of Solidarity and Power in Contract Law, 1985 Wis. L. Rev. 565; Macaulay, Stewart, Non-contractual Relations in Business: A Preliminary Study, 28 Am. Soc. Rev. 55 (1963). However, upon a closer look, there seem to be certain features common to most relational contracts that may justify treating them differently from any other form of contracting. These characteristics are: first, relational contracts are usually long-term contracts in which people invest a considerable part of their lives, and they are often indeterminate in duration (at least as far as the parties' expectations are concerned); second, the parties typically enter such relationships for the benefits they gain while the contract is in force and thus tend to underestimate the importance of the surplus upon termination; and third, discussing at the negotiation stage the allocation of profits upon termination may lower the likelihood of achieving cooperation and trust, two elements that are crucial to the success of relational contracts. The combination of these three features makes parties to most relational contracts reluctant to negotiate the question of how to divide the surplus upon termination when they enter the contractual relationship. The parties' inattention to the issue upon entering the contract does not mean it is unimportant to them. Conversely, it may suggest that courts and legislators are both allowed and required to intervene in order to ensure the just division of the surplus upon termination in the context of relational contracts.4 4Admittedly, not all relational contracts have all three features mentioned in the text. The relationships between academic institutions and their students, for example, are relational contracts, in which the skills that remain after the contractual term is over are just as important to the parties when entering the contract as the experiences gained during performance. Obviously, the relevance of the present article to such relational contracts is limited. This article offers new, and hopefully thought-provoking, insights into the dilemma of how to divide the surplus from relational contracts upon termination. The argument has two parts, one descriptive and one normative. Descriptively, the article demonstrates that the way such allocation problems are dealt with in the common law world was considerably transformed during the twentieth century. Under classical contract law,5 5The term “classical contract law” refers to a conception of the law of contract that evolved in the common law during the eighteenth and nineteenth centuries and was based on the power of the individual will to bind itself. For two fascinating accounts of the formation of classical contract law, see P.S. Atiyah, The Rise and Fall of Contractual Freedom (1979) and Roy Kreitner, Calculating Promises (2007). the value that survived after the termination of any contract, including relational contracts, was allocated according to the property rights of the parties upon termination, unless the parties agreed otherwise. In other words, the default rule, which the parties could modify at will, was that each party received his or her property at the end of the contractual relationship, without having to compensate the other party for any value that was added during the contractual period. In common law jurisdictions today, in contrast, the allocation rules for many long-term relational contracts are different. They are frequently based on a just division of the surplus between the former contracting partners, as in the case of marriage;6 6 See infra Part I.A. on monetary restitution of the fair value of the surplus, as in the case of commercial agency;7 7 See infra Part I.B. or on compensation that is based on some secured payments promised in advance rather than on the value of the surplus, as in the case of employment contracts.8 8Modern employment contracts typically include some sort of payments that the employee receives upon termination of the contractual relationship (i.e., retirement pensions and severance plans). In most cases, these payments are not based on the value of the workplace at the time of retirement (i.e., they are uncorrelated with the surviving value). Obviously, there are some exceptions to this rule (e.g., stock options). Regrettably, the discussion of employees' rights upon termination is a vast subject that extends beyond the scope of this article. Furthermore, the ability of the parties to deviate from the default rule has been considerably limited, and in some cases even forestalled, at least if the private arrangement provides less than some minimal benchmark. In its normative part, the article provides economic arguments that support this transformation from the traditional property-based default rule to modern fairness-based quasi-mandatory rules.9 9The term “quasi-mandatory” refers to legal rules that are not mandatory per se, yet a party who wishes to deviate from the default is subject to considerable transaction costs. First, it offers a justification for switching the default from property to fairness by employing an extension of Ayres and Gartner's concept of penalty-default rules.10 10 Ayres, Ian & Gertner, Robert, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 Yale L.J. 87 (1989). However, Eric Posner argued that penalty default rules are a figment of the imagination and that they cannot be found in reality. See Posner, Eric, There Are No Penalty Default Rules in Contract Law, 33 Fla. St. U. L. Rev. 563 (2006). For Ayres's rebuttal, see Ayres, Ian, Ya-Huh: There Are and Should Be Penalty Defaults, 33 Fla. St. U. L. Rev. 589 (2006). Evidently, at least if we adopt an expansive definition of the “penalty default” concept, this article supports Ayres's position that there are penalty default rules out there. Typically, the party who is expected to benefit from a property-based default rule is the more informed and sophisticated contractor (such as the husband, manufacturer, or employer). It is thus justified, according to the penalty-default theory, not to base the division of the surplus that survives after the contract is terminated on the method the strong party would prefer, but instead on a scheme that would make him negotiate an inefficient default. Given this justification for the fairness-based default rule, the article goes on to argue that partly limiting the opportunity to contract around the default rule is not necessarily inefficient. As long as the parties are able to choose between different contractual regimes, which allocate the risk for the value of the surplus upon termination according to their preference, they will be able to adapt the distribution to reflect the efficient mix of incentives and risk bearing. The fact that their choice is limited, in the sense that the contract must provide a minimum level of protection for the weak party, is thus not a reason to assume the parties will not be able to efficiently regulate their postcontractual relationship. This argument will be presented as follows. Part I presents the descriptive claims that many common law jurisdictions have established default rules for what courts and legislature conceive as just ex post distributions of the surplus generated by relational contracts and that these default rules have hardened into more binding mandatory or quasi-mandatory rules over time. It goes on to prove these claims by reference to cases of distribution of assets upon divorce or through the division of goodwill upon commercial agency termination. Part II provides some basic tools to analyze the efficiency effects of the division of the surplus upon termination in the context of relational contracts. Part III presents and defends the normative claim that establishing a penalty-default rule of just distribution is appropriate in the context of relational contracts. Part IV provides the condition for the further normative claim that making this default rule quasi-mandatory or mandatory is not necessarily objectionable on efficiency grounds. Short concluding remarks about the need to balance between the requirements of distributive justice and efficiency end the article. Long-term relational contracts often serve as vehicles to achieve cooperation for the duration of the contractual relationships. Marriage is probably the most prominent example of such relational contracts, but other types of long-term contracts, such as commercial agencies and employment contracts, demonstrate the same general pattern. Parties enter long-term relational contracts—or at least are expected to do so—for the benefits they can gain from cooperation, while it lasts, not for the profits they can extract upon their termination. Again, marriage is a prominent example. We expect people to get married in order to enjoy their life together, irrespective of whether love has anything to do with it, and thus we treat with shame “gold diggers,” who enter into the relationship in order to make a profit upon its dissolution.11 11The contempt for and fear of “gold diggers” is well reflected in popular culture. The gold digger was a very popular subject in the comic literature of the early twentieth century. See, e.g., Anita Loos, Gentlemen Prefer Blondes (1925); P.G. Wodehouse, A Damsel in Distress (1919). Recently it reappeared in popular culture through Kanye West's 2005 song by the same name. Kanye West, Gold Digger (Roc-A-Fella Records 2005). Nonetheless, relational contracts, like any contractual form, are not perpetual. All relational contracts, even those entered into with the purest of hearts, come to an end. When they do, there is often the question of how to divide the value that survives. Matrimonial property that was accumulated during the marriage must be divided between the couple (or their heirs) upon divorce or the death of one party. Goodwill and knowledge attained during the successful operation of a commercial agency must be assigned after the agreement is terminated by either the agent or the manufacturer. The contributions of a productive employee to the operation of her workplace must be reallocated when she quits or is laid off. Put more generally, the termination of a long-term relational contract frequently leaves value that survives the end of the contractual relationship (hereafter “the surviving value”). It thus raises the legal question of how to allocate the surviving value between the parties. The classical concepts of contract law provided a very simple solution to the postcontractual allocation dilemma: it was decided either by the agreement or, if the agreement was silent, according to the law of property. In other words, classical contract law adopts a property-based default rule for allocating the surviving value. Such a rule views contracts as a temporary suspension of the proprietary regime. Both before and after the contract, the parties' legal relationships are governed by the law of property. It is only for the duration of the contract that the parties are assumed to adopt a different legal regime, one that is regulated by the terms of the agreement. Naturally, the parties are free to agree upon the structure of the postcontractual property regime, and they are also allowed to circumvent the rules of property for the postcontractual era. But as long as they are silent about the matter, they are assumed to accept the allocation that is achieved by applying the law of property. While the property-based default rule remains the governing allocation rule for most contracts, it seems to be losing its grip with respect to long-term contracts in general12 12An example of long-term contracts that are typically not categorized as relational contracts, but went through at least part of this transformation, is leases. According to classical English contract law, a landowner was not required to pay for the tenant's fixtures after the lease was surrendered. The reason for this was that, as a matter of property law, the tenant's fixtures were part of the freehold and thus belonged to the landowner after the lease was terminated. The rule created discontent in England and was altered by legislation, first with respect to agricultural leases (Agricultural Holdings Act of 1883, Sec. 1) and, almost half a century later, with respect to commercial leases as well (Landlord & Tenant Act, 1927, Sec. 1). The background for this legislation is explained in Atiyah, supra note 5, at 634–37, 746–47. See also Haley, Michael, Compensation for Tenants' Improvement: a Valediction, 11 J. Legal Stud. 119 (1991). and relational contracts in particular. Typically, though not always, the process occurred in two stages. In the first stage, the content of the default rule was transformed in a way that equitably divides the surviving value between the parties, regardless of their postcontractual property rights. In the second stage, the default status of the allocation rule was restricted, and it was turned into a mandatory (or quasi-mandatory) allocation rule. The upshot of these developments was the creation of mandatory (or quasi-mandatory) division rules that guarantee an ex post equitable division of the surviving value, regardless of the postcontractual proprietary regime. It is important to note that the transformation from the traditional property-based default rule to modern fairness-based quasi-mandatory rules was not achieved through some general evolution of a new principle that applied to all relational contracts, but instead through specific and seemingly sporadic changes in the rules that regulate specific kinds of relational contracts. Furthermore, in many cases, these modifications were effected through legislation and not by the courts. The following subparts demonstrate both the transformation and its segmented nature, through two distinct forms of relational contracts: marriage and commercial agency. Until the nineteenth century, Anglo-American law adored the concept of “coverture,” according to which, the wife's legal personality merged into her husband's legal personality during the period of marriage. As the famous maxim attributed to Blackstone states, “the husband and wife are one, and that one is the husband.”13 13The actual quotation reads as follows: “By marriage, the husband and wife are one person in law: that is, the very being or legal existence of the woman is suspended during the marriage, or at least is incorporated and consolidated into that of the husband; under whose wing, protection, and cover, she performs every thing; and is therefore called in our law-french a feme-covert.” 1 William Blackstone, Commentaries 442 (1765). This legal concept did allow women to regain legal control over their own property upon divorce, but because any property acquired during the marriage was owned by the husband, the rule applied only to property that belonged to the wife before entering the marriage. In fact, a wife's “right of dower” entitled her to only part of the property that was acquired during the marriage upon the husband's death,14 14The right of dower allowed the widow to claim one-third of the land accumulated during the marriage upon waiving her share in the inheritance of her husband. R.S. Donnison Roper, A Treatise of the Law of Property Arising from the Relation between Husband and Wife 332 (2d ed. 1826). and this only if she was married to him at the time of his death or if the dissolution of the marriage was not her own fault.15 15For the effect of divorce on the right of dower, see Denny, Collins, Effect of Divorce upon the Inchoate Right of Dower, 9 Va. L. Rev. 58 (1922). The abolition of the coverture system by legislation, first in the United States and later in England,16 16 See Chused, Richard, Married Woman's Property Law: 1800–1850, 71 Geo. L.J. 1359 (1983). did not do much to improve the state of women's claims to the matrimonial property. Indeed, it was now possible for married women to accumulate property during their marriage, but because most of the matrimonial property, especially land, was recurrently registered solely in the name of the husband, the wife still had no rights to it upon divorce.17 17 See Marcus, Isabel, Locked In and Locked Out: Reflections on the History of Divorce Law Reform in New York State, 37 Buff. L. Rev. 375, 406– 09 (1983) (pointing to the fact that, even after the enactment of The Married Woman's Property Act, “strict title governed the ownership of property brought to or acquired during a marriage, as well as distributed at divorce”). The first step toward a more equal division of matrimonial property upon divorce came only during the twentieth century, with the confused case law that evolved with respect to beneficial ownership in matrimonial property. Courts in many common law jurisdictions found it unacceptable that the division of property upon divorce must be decided strictly according to legal title. They thus developed a very complex and incoherent body of law regarding beneficial ownership, which allowed for a just division of family assets based on conceptions of equity and inferred intents.18 18 See id. at 434–58; Greene, Scott, Comparison of the Property Aspects of the Community Property and Common-Law Marital Property Systems and Their Relative Compatibility with the Current View of the Marriage Relationship and the Rights of Women, 13 Creighton L. Rev. 71 (1979). It is interesting to note that such endeavors assume as given the property-based allocation rule and attempt to circumvent its unjust result by redefining the law of property. Put another way, courts found it easier to reallocate property rights during the marriage than to replace the traditional property-based allocation rule that regulated the division of property upon its dissolution. That is certainly a very clear indication of the strong hold the traditional rule has on the minds of jurists in the Anglo-American world. While the effort to offer redress through property was partially successful, it created numerous problems and uncertainties.19 19The English precedents on this issue are notoriously vague and hard to reconcile. See, e.g., Pettitt v. Pettitt [1970] A.C. 777 (H.L.); Gissing v. Gissing [1971] A.C. 886 (H.L.). In any case, since the 1970s, a new approach has been adopted to deal with the problem of dividing matrimonial property upon divorce or death, usually through legislation. At the heart of this approach is the recognition that property-based allocation rules are inapt to achieve just distribution of the surplus that was created during the marriage. As the House of Lords put it, the prevailing view in many common law jurisdictions is that “[t]he question of who owns what takes second place to the statutory criteria” when deciding on the distribution of property if the couple divorce or if one of them dies.20 20Stack v. Dowden [2007] UKHL 17 (Baroness Hale of Richmond) (appeal taken from [2005] EWCA (Civ) 857) (concerning an unmarried couple). The recognition that property-based rules should not dictate the way we allocate the matrimonial property after the marriage is dissolved is a clear departure from the traditional approach to allocating the surviving value. It is based on the conviction, now shared by all, “that the outcome on these matters, whether by agreement or court order, should be fair.”21 21 See, e.g., White v. White [2001] 1 A.C. 596, 599 (H.L.) (Lord Nicholls of Birkenhead) (appeal taken from the Court of Appeal (Civil)) (U.K.). In essence, it represents the view that dissolving the marriage contract merits reallocation of the surviving value in a way that may conflict with the manner by which the parties managed their assets while they were married. Married couples do not simply suspend the rules of property inter se for the duration of the contract. Instead marriage creates a shared value which, upon marital dissolution, must be reallocated from scratch. Is this move from property-based allocation to fairness-based allocation strictly a matter of defining the default rule? In a weak sense it is. In most jurisdictions, a couple is allowed—both before and during the marriage—to sign a contract (prenuptial and postnuptial agreements), by which they settle the division of property in case of divorce or death, perhaps among other issues. Hence, if they wish to alter the allocation rule, they have the legal means to do so. At best, however, this possibility changes the option to deviate from the fairness-based rule into a quasi-mandatory rule. Not only may it be extremely difficult to ask one's partner to sign such an agreement at the start of the relationship,22 22 See Frantz, Carolyn & Dagan, Hanoch, Properties of Marriage, 104 Colum. L. Rev. 75, 96 (2004) (“Making specific marital agreements is difficult; romance and hard-headed business bargaining are not easily blended together, which may explain why explicit contracts in the marital context are not very frequent.”). but prenuptial and postnuptial contracts are not always enforced by the courts upon divorce or death, especially if the agreement seems unconscionable.23 23Courts' willingness to enforce prenuptial and postnuptial agreements varies among jurisdictions. In England, such agreements used to be “of very limited significance,” but in recent years courts have been willing to “take the terms of the agreement into account.” Nigel Lowe & Gillian Douglas, Bromley's Family Law 1012–14 (10th ed. 2007). In contrast, courts in the United States usually give more weight to such agreements. Most of them, though, still retain considerable discretion to intervene in cases where the agreement seems unfair. See Roy, Robert, Annotation, Enforceability of Premarital Agreements Governing Support or Property Rights upon Divorce or Separation as Affected by Fairness or Adequacy of Those Terms, 53 A.L.R.4th 161 (1987). Much like marriage, a successful commercial agency requires long-term cooperation between the parties.25 25For a comprehensive economic analysis of this interdependency within the franchise relationship, see Hadfield, Gillian K., Problematic Relations: Franchising and the Law of Incomplete Contracts, 42 Stan. L. Rev. 927 (1990). If successful, these mutual efforts create market value in the form of goodwill, which the principal and his agent share during the contractual period through the agreed commission structure. The termination of the agency leaves the agent with the personal reputation she made for herself, but with no legal title to the goodwill of the product. Thus according to the classical property-based concept of dividing the surviving value, unless the parties agreed otherwise, after the termination of the contract, the agent had no claim to a share in the market that she helped to develop. Indeed, until the mid-twentieth century, the common law position was that “[p]rima facie the liability to pay commission in cases of this kind ceases as to future trade with the cessation of the employment in the absence of a reasonably clear intention to the contrary.”26 26Marshall v. Glanville [1917] 2 K.B. 87, 92 (Eng.). The first crack in this stern property-based attitude came through creative contractual interpretations, which recognized the agent's right to reimbursement, commissions, or other forms of compensation in the postcontractual period even without any explicit provision. For instance, in the case of Beebe v. Columbia Axle Co.,27 27117 S.W.2d 624 (Mo. Ct. App. 1938). a Missouri Court of Appeals ruled that, although a principal has the right to revoke an indefinite agency at will, it nevertheless will be required to compensate the agent for services rendered if it appears that the agent, induced by his appointment, has in good faith incurred expense and devoted time and labor in the matter of the agency without having had a sufficient opportunity to recoup such from the undertaking … for the law will not permit one thus to deprive another of value without awarding just compensation.”28 28 Id. at 629. The court recognized the default status of its ruling by noting, “[C]ontracts of agency are numerous and widely variant in their objects, purposes, and terms, so that the question of the compensation of the agent when the agency has been revoked by the principal will depend on a variety of circumstances.”Id. This ruling, which came to be known as the “Missouri Rule” in agency law, was followed by other jurisdictions as well.29 29 See Gellhorn, Ernest, Limitations on Contract Termination Rights—Franchise Cancellations, 1967 Duke L.J. 465, 479– 80 (1967); Wangerin, Paul, Damages for Reliance Across the Spectrum of Law: Of Blind Men and Legal Elephants, 72 Iowa L. Rev. 47, 55– 56 (1986); Buckner, D.E., Annotation, Termination by Principal of Distributorship Contract Containing No Express Provision for Termination, 19 A.L.R.3d 196, §16b (1968). It may even account for two of the most important decisions in American contract law, the famous cases of Goodman v. Dicker30 30169 F.2d 684 (D.C. Cir. 1948). and Hoffman v. Red Owl Stores Inc.31 31133 N.W.2d 267 (Wis. 1965). For a historic account of this case, see Scott, Robert E., Hoffman v. Red Owl Stores and the Myth of Precontractual Reliance, 68 Ohio St. L.J. 71 (2007). For my own attempt to explain Hoffman, see Grosskopf, Ofer & Medina, Barak, A Revised Economic Theory of Disclosure Duties and Break-up Fees in Contract Law, 13 Stan. J.L. Bus. & Fin. 148, 168– 72 (2007). Notably, Goodman and Hoffman, which served as the bedrock of the controversial Section 90 of the Restatement (Second) of Contracts and the promissory estoppel doctrine it encapsulated,
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