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Article Excerpt
Restatement Second of Contracts provided that contract law serves to protect one or more of three interests: the expectation interest, the reliance interest, and the restitution interest. There is, however, a fourth interest that contract law should and does protect: the disgorgement interest, which is the promisee's interest in requiring the promisor to disgorge a gain that was made possible by the promisor's breach, but did not consist of a benefit conferred on the promisor by the promisee. It is not clear why Restatement Second excluded the disgorgement interest. Perhaps the drafters believed that this position was compelled by positive law. That proposition, however, would have been doubtful even when Restatement Second was published, and it is clearly wrong today: some appellate cases, and a handful of trial court cases, have denied protection to the disgorgement interest, but a dozen or so American appellate cases, as well as cases decided by the highest courts of several other common law jurisdictions, have afforded such protection. Alternatively, the drafters of Restatement Second may have believed that the disgorgement interest should not be protected as a normative matter. That proposition also cannot be supported. On the contrary, there are strong efficiency reasons, as well as moral reasons, for protecting the disgorgement interest, because in certain categories of cases, protection of that interest in contract law is necessary to provide efficient incentives to the promisor, to effectuate contracts, or to prevent unjust enrichment. Of course, the disgorgement interest should not be protected in all cases in which a promise is legally enforceable, any more than the reliance interest, the restitution interest, or, for that matter, the expectation interest are protected in all cases. Rather, as in the case of those interests, the disgorgement interest should be protected when appropriate, and in certain categories of cases protection of the disgorgement interest is always appropriate.
TABLE OF CONTENTS INTRODUCTION I. THE DISGORGEMENT INTEREST OUTSIDE CONTRACT LAW II. THE PUZZLE OF RESTATEMENT SECOND A. Positive-Law Considerations B. The Causation Arguments C. The Theory of Efficient Breach D. The Efficiency of Expectation Damages III. WHY CONTRACT LAW SHOULD AND DOES PROTECT THE DISGORGEMENT INTEREST A. The General Argument B. Cases in which the Promisee Has Bargained for the Promisor's Gain from Breach C. Disgorgement in Lieu of Specific Performance D. Disgorgement as a Surrogate for Expectation Damages E. Bargains Designed to Serve Interests Other Than Profit-making F. Externalities G. Disgorgement of Costs Saved by Breach IV. WHY DON'T WE SEE MORE DISGORGEMENT IN CONTRACT LAW? V. THE PROBLEM OF APPORTIONMENT CONCLUSION
INTRODUCTION
Restatement Second of Contracts section 344 famously provides that judicial remedies in contract law serve to protect one or more of three interests of a promisee:
(a) his "expectation interest," which is his interest in having the benefit of his bargain by being put in as good a position as he would have been in had the contract been performed,
(b) his "reliance interest," which is his interest in being reimbursed for loss caused by reliance on the contract by being put in as good a position as he would have been in had the contract not been made, or
(c) his "restitution interest," which is his interest in having restored to him any benefit that he has conferred on the other party. (1)
There is a striking omission from this list: the disgorgement interest, which is the promisee's interest in requiring the promisor to disgorge a gain that was made possible by her breach but did not consist of a benefit conferred on her by the promisee. (2)
The disgorgement interest is the mirror image of the expectation interest. As stated in section 344(a), the expectation interest is the promisee's interest in being put in as good a position as he would have been in if the contract had been performed. Accordingly, perfect expectation damages would make the promisee indifferent between receiving performance, on the one hand, and receiving damages, on the other. In contrast, as Robert Cooter and Thomas Ulen have pointed out, disgorgement places the promisor in the position that she would have been in had the contract had been performed. Accordingly, perfect disgorgement would make the promisor indifferent between performing, on the one hand, and paying damages, on the other:
When disgorgement is perfect, the injurer is indifferent between doing right, on the one hand, or doing wrong and paying disgorgement damages, on the other hand. Thus, perfect disgorgement is identical to perfect compensation, with the roles of injurer and victim reversed. The injurer achieves no gain from the wrongdoing net of perfect disgorgement damages, just as the victim suffers no harm from the injury net of perfectly compensatory damages. (3)
The omission of the disgorgement interest in section 344 was plainly deliberate. For one thing, the section is written as an exclusive catalog. For another, shortly after publication of Restatement Second, Allen Farnsworth, the Reporter for much of the Restatement, including section 344, wrote a leading article entitled Your Loss or My Gain?, in which he argued on normative grounds against recognition of the disgorgement interest in contract law. (4) Furthermore, at the time Restatement Second was published, it was widely assumed by commentators that the disgorgement interest was not protected in contract law. For example, Dobbs's treatise on remedies states:
Writers recognize that there is no general rule allowing restitution of profits [for breach of contract], and plaintiffs seldom seek such restitution.... It is "commonly assumed" that the breacher is not liable for collateral benefits.... The assumptions and practices of the bar, the implications of exceptional cases and the commentary all justify the belief that there is, in practice, a rule against restitution of profits.... (5)
In contrast, the thesis of this Article is that contract law should and does protect the disgorgement interest. The Article proceeds as follows: In Part I, after showing that the disgorgement interest is widely recognized outside contract law, I address the puzzle why Restatement Second nonetheless rejected that interest. Perhaps the Restatement position was based on the belief that this rejection was compelled by the case law. Alternatively, the Restatement position may have been based on the theory of efficient breach--which was endorsed in a Reporter's Note to the Chapter on Remedies--or other unspoken normative considerations. As I show in Part II, however, rejection of the disgorgement interest is not compelled by the case law; the theory of efficient breach cannot be sustained; and other normative arguments against recognition of the disgorgement interest in contract law are equally unpersuasive. In Part III, I develop categories of cases in which the disgorgement interest in contract law should be protected on the basis of normative considerations, and I discuss a number of cases which have done exactly that. In Part IV, I address the question, if contract law should and does protect the disgorgement interest, why don't we see more disgorgement cases than we do? Finally, in Part V, I consider whether and when a promisor's gain from breach should be apportioned between the promisor and the promisee.
I. THE DISGORGEMENT INTEREST OUTSIDE CONTRACT LAW
Damages in private law are usually based on the loss that the plaintiff has suffered as a result of the defendant's wrong. Often, however, a plaintiff's recovery is measured not by his loss, but by the wrongdoer's gain. Cases involving the recovery of a wrongdoer's gain are of two types. In the first type, the plaintiff seeks to recover the value of a benefit the plaintiff conferred upon the wrongdoer. This type of recovery protects the interest that Restatement Second section 344 calls the restitution interest. In the second type, the plaintiff seeks to recover the value of a gain that resulted from or was made possible by the defendant's wrong, but did not consist of a benefit that the plaintiff conferred on the defendant. This type of recovery protects the disgorgement interest. (6)
Disgorgement is an important remedy in various fields of law. For example, it is a central remedy in the law of fiduciary obligations. A fiduciary who wrongfully makes a personal gain through the use of his position, or of property or information that he holds through his position, must disgorge that gain to his beneficiary even if the beneficiary has suffered no loss from the wrong. This principle is exemplified in an illustration to Restatement Third of Agency:
P, who owns a stable of horses, employs A to take care of them. While P is absent for a month, and without P's consent, A rents the horses [for his own personal gain] to persons who ride them. Although being ridden is beneficial to the horses, A is subject to liability to P for the amount A receives for the rentals). (7)
A fiduciary is made liable for his gain in such cases partly because a person should not profit from his own wrong, partly because requiring disgorgement gives effect to the beneficiary's implicit expectations, and partly because disgorgement is an instrument of efficiency, since it shapes the conduct of fiduciaries to reflect the reasonable expectations of beneficiaries and provides fiduciaries with correct incentives. (8)
Disgorgement is also commonly awarded where property interests are involved. For example, if Wrongdoer appropriates Owner's property, Wrongdoer is liable in conversion for Owner's loss. Normally, Owner's damages will be measured by the market price of the converted property at the time of conversion. However, if Wrongdoer later sells the property to a third person at a higher price, Owner can require Wrongdoer to disgorge that price instead of Owner's loss. (9) If Wrongdoer uses the property, Owner can require wrongdoer to disgorge the rental value of the property, even though that value exceeds the market price of the property. (10) Similarly, a number of cases have held that if Wrongdoer trespasses on Owner's land, Owner can require Wrongdoer to disgorge the use value of the trespass--that is, the fair rental value of the trespassed property during the relevant period--even though Owner was not harmed. (11) This result is reflected in an Illustration to a Discussion Draft of Restatement Third of Restitution:
A repeatedly and intentionally trespasses on B's land, avoiding the higher costs of transportation by an alternate route and hoping to avoid paying B for a license. A's saved expenditure (the net costs avoided or the price of a license, whichever is higher) is an unjustified enrichment because it is the result of a legal wrong.... A is liable to B in restitution in the amount of A's saved expenditure, whether or not A's repeated trespass has caused any injury to B's land. (12)
II. THE PUZZLE OF RESTATEMENT SECOND
Given the well-accepted protection of the disgorgement interest in other areas of law, what explains Restatement Second's position that contract law does not protect the disgorgement interest? There are two possibilities. The drafters of Restatement Second may have held either the view that the exclusion of the disgorgement interest from section 344 was dictated by positive law or the view that the exclusion was normatively justified. At least today, neither view can be supported.
A. Positive-Law Considerations
The first possible explanation turns on positive-law considerations. As Dobbs's treatise shows, until recently it was commonly assumed by commentators that contract law does not protect the disgorgement interest. However, there is only limited support for that assumption in the case law, especially at the appellate level. Farnsworth cites no cases that directly support the proposition. Dobbs cites only one case, and instead relies primarily on "writings," "assumptions," and the "practices of the bar." (13) The single case that Dobbs cites--Burger King Corp. v. Madison(14)--is of doubtful authority. Burger King was a diversity case which purported to apply Florida law. In reality, however, the Florida Supreme Court, in cases decided both before (15) and after (16) Burger King, has given strong protection to the disgorgement interest in contract law. Restatement Second's position seems to be supported by only a few other appellate cases, principally United States Naval Institute Press v. Charter Communications, Inc., (17) and a smattering of lower-court cases. (18) In contrast, more than a dozen appellate cases decided by various state appellate courts, the United States Supreme Court, the House of Lords, and the highest courts of other common law jurisdictions have awarded disgorgement in a contract setting. (Many of these cases, along with Naval Institute, will be discussed in Part III.)
Nor is there a convincing normative argument in favor of Restatement Second's position. In the balance of this Part, I will explicate several such arguments, based on causation and efficiency. I will show that all these arguments fall.
B. The Causation Arguments
Three causation arguments against protection of the disgorgement interest in contract law are at the center of Farnsworth's leading article, Your Loss or My Gain? Farnsworth calls these arguments "cause in fact," "remote cause," and "joint cause." (19) These causation arguments are flawed in various ways. Among other things, none are really arguments against protection of the disgorgement interest in contract law. Instead, as I will show, the arguments only concern how disgorgement damages should be measured.
1. Cause in fact: saving the cost of obtaining a release from the promisee. First, Farnsworth claims that if a breach makes possible a gain that the promisor would not have realized through performance, the breach is not the cause in fact of the entire gain. The promisor, Farnsworth argues, could have arranged to realize the gain through some means other than breach--in particular, by negotiating a release from the promisee. In that case, Farnsworth argues, the gain made possible by the promisor's breach is only the amount that the promisor would have had to pay the promisee for the release. (20) So, for example, if a breach makes it possible for the promisor to gain $10,000 more than she would have gained from performance, but the promisee would have released the promisor from the contract for $4,000, Farnsworth argues that the gain caused by the breach is only $4,000, the amount the promisor gained by not obtaining the release. (21)
This reasoning is highly unpersuasive. To begin with, under any normal conception of "cause" the promisor's breach would be a cause--both a but-for and a proximate cause--of her $10,000 gain from breach. After all, the promisor is able to make the $10,000 gain from breach only because she breaches.
Putting that aside, Farnsworth's cause-in-fact argument is not really an argument against protecting the disgorgement interest in contract law. On the contrary, the argument implicitly recognizes that interest. If a promisee sued for breach, the amount that the promisor would have had to pay to obtain a release would not be an element of either expectation, reliance, or restitution damages, and could be recovered only if the disgorgement interest was protected. Accordingly, the cause-in-fact argument concerns only how much the promisor should disgorge, not whether the promisor should disgorge.
Next, there is no natural stopping point to the reasoning that the only loss caused by a breach is the amount the injured party would have required to forgo his rights. If there is a causation problem in contract law of the kind that Farnsworth's cause-in-fact reasoning depends upon, the same causation problem would affect other areas of law as well. For example, suppose an agent improperly uses her principal's property in a way that does not harm the principal. Under Farnsworth's reasoning, the principal, P, should be able to recover only the amount that he would have required the agent to pay for P's consent to the use, because that would be the only loss the agent caused in fact. The same would be true of a trustee who improperly uses trust property without harming the beneficiary, or a corporate director who improperly uses corporate property without harming the corporation. (22)
Moreover, the brute reality is that Farnsworth's cause-in-fact argument depends on a counterfactual premise. Even if the promisor could have obtained a release from the promise, she did not do so. If a promisor wants to not perform, her proper course of action is to renegotiate the contract to obtain a release or a modification. Farnsworth's cause-in-fact argument, however, treats a breaching promisor who wrongly fails to renegotiate just as well as a promisor who does properly renegotiate, and as a result does not breach. To measure the promisee's damages as if the promisor had renegotiated, when in fact she did not, is to reward the promisor for doing the wrong thing and to remove from the promisor an incentive to do the right thing. This problem is well brought out in a comment on Farnsworth's article by one of my former students, which I here paraphrase:
The logical structure of Farnsworth's argument is as follows: Instead of not breaching her contract, the promisor sold to a third party (the "overbidder"). But the promisor could have negotiated with the promisee for a release, which would have allowed her both to not breach and to sell the commodity to the overbidder. So instead of disgorging the profit from selling to the overbidder, the promisor should pay for not having negotiated with the promisee for a release, because what really prevented the promisor from not breaching was not having obtained a release. But who cares what the promisor could have done? The availability of negotiating for the release makes the promisor even more culpable. She had the opportunity to negotiate for the release, which would have allowed her both to not breach and to sell to the overbidder. But instead she chose to not negotiate for the release, and to breach. If we think that not breaching contracts is important, we need to give incentives for doing all of not breaching, negotiating for a release, and, if the release is obtained, selling to the overbidder. Disgorgement would do this, because it takes away the incentives to just breach. (23)
Finally, a measure of recovery based on the cost of obtaining a release would be virtually unadministrable, because the amount that a promisee would have required to give a release is not only unknown but in most cases unknowable.
2. Joint cause; apportionment. Next, Farnsworth argues that recognition of the disgorgement interest would raise a problem that he calls joint cause, a term he uses to describe cases in which the promisor's gain from breach resulted in part from the promisor's own skill and diligence. (24) For example, suppose Seller contracts to sell to Buyer the Acme Hotel in Chicago for $60 million, with closing in one month. After making the contract, Seller continues to seek out other buyers for the Acme, and locates Overbidder. Overbidder has a strategic need for the Acme, because he is putting together a hotel chain and needs a hotel in Chicago to complete the chain. Because of this need, Overbidder is willing to pay $65 million for the Acme, which is more than anyone else would pay. Seller sells the Acme to Overbidder for that price.
Assume that the market value of the Acme Hotel, based on extrapolation from the sales of comparable hotels, is $61 million. If specific performance is unavailable (because, for example, Seller completes the sale of the Acme to Overbidder before Buyer can get to court), Buyer's expectation damages would be $1 million, leaving Seller with a gain of $4 million from the breach. Some part of this $4 million gain, however, resulted from Seller's skill and diligence in locating Overbidder. How, Farnsworth asks, is a court to respond, in such a case, to the promisor's argument that some apportionment from the gain from breach is required.? (25)
As in the case of the cause-in-fact argument, "joint cause" is not an argument against protecting the disgorgement interest in contract law. Instead, it is only an argument about how to measure disgorgement damages, because unless disgorgement is awarded, there is nothing to apportion.
Furthermore, apportionment will seldom be a real issue in contract disgorgement cases. To begin with, in many or most cases the gain made possible by a promisor's breach will not be a result of the promisor's skill and diligence. For example, in a variant of the Acme Hotel hypothetical, Overbidder may offer to buy the Acme from Seller without Seller having solicited the offer, because Overbidder independently identified the Acme as a desirable purchase. In such cases, Seller's skill and diligence will not have contributed to her gain.
Even where part of the promisor's gain from breach does result from her skill and diligence, often it will be improper to give her credit for that part of the gain. If an agent wrongly uses his principal's property to make a gain (as in the stable-horse illustration in Restatement Third of Agency), an apportionment of part of the gain to the agent, on the ground that the agent's skill and diligence contributed to the gain, would be improper, because it would reward the agent for committing a wrong and would subvert the agent's duty of loyalty. Similarly, as I will show in Section III.B, in a case like Acme Hotel, even if Seller finds Overbidder through the exercise of skill and diligence, Seller's gain from breach should not be apportioned between Seller and Buyer, because Seller wrongfully breached the contract by searching for an overbidder after she had contracted to sell to Buyer.
There are cases in which an apportionment of the gain from breach is appropriate. I will discuss the principles...
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