Decision Costs, Contract Excuse, and theWestinghouse Commercial Impracticability Case

DONALD VANDEGRIFTSchool of Business, Trenton State College, Hillwood Lakes, CN4700, Trenton, NJ 08650-4700, e-mail: vande-don@trenton.edu

Abstract

The literature on performance excuses does not consider the cost of determining whether the conditions estab-lished for contract excuse are met. We must incorporate these costs to determine which contract laws are effi-cient. I show that while the costs of determining whether the conditions for excuse are met will rise with the valueof the contested performance, the benefits are unrelated to the value of performance. I conclude that the courtshould not allow excuse if the value of the contested performance is large.

Keywords: contact excuse, DUP, impossibility, commercial impracticability

1. Introduction

In a seminal paper, Tullock (1967) showed that traditional models of monopoly had under-estimated the efficiency costs associated with monopoly. According to Tullock, a broadclass of governmental barriers lead to directly unproductive profit seeking (DUP),1 andthus the standard allocative efficiency triangle captures only a fraction of the efficiencycost of monopoly. Like the pre-Tullock monopoly literature, the literature on contractexcuse fails to incorporate the costs of DUP.

Previous work on contract excuse (Posner and Rosenfield, 1977; Perloff 1981; Bruce,1982; Goldberg, 1988; White, 1988; Sykes, 1990; Trimarchi, 1991) has focused on thebenefits of contract excuse (for example, more efficient risk allocation). In so doing, itconsiders the conditions under which the court should excuse performance to improvewelfare or maximize the joint value of the contract. But the existing rules for contractexcuse, as well as those proposed in the literature, require that courts make decisionsbased on factors that they cannot directly observe. Thus, the literature ignores the extra-ordinary incentives created for costly litigation in a world in which facts are unclear, andcourts must draw inferences from these facts.2 Rather than considering the conditionsunder which court excuse would improve welfare, courts should consider whether thesocial benefits of allowing excuse under the proposed conditions exceed the costs of deter-mining whether the conditions established for excuse are met.

If courts can determine costlessly and without error whether the conditions for excuseare met, contractors have no incentive to use performance excuses strategically. But if thepotential for court error exists, there is a real danger that contractors will use performance

European Journal of Law and Economics, 4:41–54 (1997)© 1996 Kluwer Academic Publishers

excuses strategically. Under the doctrines of commercial impracticability and frustrationof purpose, courts condition excuse on nonobservable factors like “foreseeability.”Deciding cases based on nonobservable factors increases court costs. In addition, nonob-servable factors increase the probability of court error. Errors increase because the inquiryis complex and because agents have an incentive to distort information or disclose it selec-tively.

I will argue that as the value of the contested performance3 increases, the probabilitythat the net benefits of commercial impracticability and frustration of purpose are nega-tive also increases. This occurs for two reasons. First, the cost of determining whether theconditions for excuse are met rises with the value of performance. Economic agents willspend more on litigation as the amount contested at trial rises. If a claim for excuse yieldsexpected profits, the contractor will spend any dollar on litigation that yields an expectedpayoff greater than that dollar. Even if defendants expected that courts will not releasethem from their obligations, these performance excuses provide a mechanism for defen-dants to redistribute the gains to a contract. Under threat of a long and drawn-out courtbattle, plaintiffs may agree to a redistribution.

Second, the social benefits of contract excuse are unrelated to the value of perfor-mance.4 Maximizing the joint contract value (that is, social benefits) requires that courtschoose contract clauses that the parties would have chosen at contract initiation (Posnerand Rosenfield, 1977; Perloff, 1981; Bruce, 1982; Goldberg, 1988; White, 1988; Sykes,1990). But at contract initiation, the parties have an incentive to include in the contractclauses that have high expected benefits. Any contract clauses that the courts infer ex postmust necessarily have low expected benefits. If a commercial contract dispute involves acontested performance with a large market value, the cost of determining whether the con-ditions are met will exceed the social benefits of contract excuse. Courts should, therefore,not permit excuse under commercial impracticality, frustration of purpose, or any of therules proposed in the literature that condition excuse on nonobservable factors if the valueof the contested performance is large.

To further demonstrate the high costs of determining whether the conditions for excuseunder the commercial impracticability and the frustration-of-purpose defenses are met, Iexamine the Westinghouse commercial impracticability case (Westinghouse cited com-mercial impracticability and refused to perform on uranium supply contracts after the mar-ket price of uranium tripled). Because of the extensive third-party reports of the eventsleading up to the trials and the negotiations both inside and outside the courtroom, theWestinghouse case is useful to point out the strategic aims that the commercial impracti-cability defense may serve. While the Westinghouse case was large, the mechanics of thelegal maneuvering are likely to be the same for smaller cases.

I divide the discussion into three sections. First, I survey the literature on contractexcuse and argue that it does not consider the cost of determining whether the conditionsfor excuse are met. Second, I construct a simple model to consider the benefits and costsof contract excuse. In the final section, I use the Westinghouse commercial impracticabil-ity case to support several of the propositions put forth in the preceding sections and estab-lish a number of additional points. First, private-party negotiations are faster and moreeffective than court ordering.5 The possibility of a court-imposed solution often slows

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down the negotiation process. Second, the promisee rarely has an incentive to drive thepromisor into bankruptcy.6 Finally, current performance excuses may cause the promisorto wait to communicate the severity of the situation.7

2. Contract excuse and the impossibility literature

Economic analyses of the impossibility-related defenses generally do not consider thecosts of determining whether the conditions for excuse are met. Thus, the analyses includeonly the possible benefits of excuse.

When the court decides a performance excuse case, it decides whether to reallocate theburden of a contingency that has increased the cost of performance to the promisor ordecreased the benefits to the promisee. For instance, the court allocates the burden of thecontingency to the promisee when it excuses a promisor from performing on a contract.Posner and Rosenfield (1977) argue that excuse should be allowed when the promisee isthe superior risk bearer.

If the promisor is the superior risk bearer, nonperformance should be treated as breach.A promisor may be the superior risk bearer and thus be held to his promise for two reasons.First, the promisor might be better able to prevent the risk from materializing. Posner andRosenfield (1977) contend that excuse “would be inefficient in any case where the promisorcould avoid the risk at lower cost than the expected cost of the risky event” (p. 90). Second,the promisor might be the superior insurer. Consequently, even though the promisor couldnot at reasonable cost have prevented the event, she still may be held to her promise. Bothrisk appraisal costs and transactions costs determine which party is the cheaper insurer fora particular event. Risk appraisal costs comprise the cost of determining the probability thatthe risk will materialize and of measuring the magnitude of the prospective loss.

It is not possible to observe easily which party is the superior risk bearer in Posner andRosenfield’s framework. One must infer a conclusion from economic evidence that isoften less than clear cut. Posner and Rosenfield (1977) admit, “When the two key para-meters of the economic analysis point in opposite directions, the analysis is indeterminateon a general level and must proceed to estimation of their relative empirical importance”(p. 102). The authors also exhibit some sensitivity for the cost of such an undertaking (p.103):

But there is a question whether so microscopic an examination of the facts is an appro-priate predicate for decision, in light of the administrative costs, discussed in Part I, ofapplying the impossibility doctrine on a highly particularistic case-by-case basis ratherthan on the basis of rules that decide all of the cases within a specific category in thesame way—for example, a rule deciding all lease discharge cases either in the lessee’sor in the lessor’s favor. Unfortunately, it is unclear, a priori, which would be the moreefficient rule.

Although Posner and Rosenfield realize there are administrative costs involved, theyattempt no discussion of DUP that would occur under such a proposal.

DECISION COSTS, CONTRACT EXCUSE, AND IMPRACTICABILITY 43

Several other papers follow the Posner and Rosenfield risk aversion framework. Eachconcentrates only the benefits of excuse and ignores the costs (DUP). Perloff (1981) con-siders excuse in a model of a forward market. Bruce (1982) refines the original frameworkto consider the effect of informational imperfections on the optimal allocation of liabilityand the decision to mitigate damages. Like Posner and Rosenfield, White (1988) arguesthat the critical consideration is risk aversion. However, White considers all unperformedcontracts as breach of contract cases. The argument requires that courts perform a two-stepprocess. First, courts must determine the expectation damages. Second, the courts mustconsider reducing damages based on relative risk aversion. Efficient damage remedies aresmallest when the performing party is risk averse and the nonperforming party is risk neu-tral. Negative and zero damages (discharge) occur in rare instances. Sykes (1990) followsWhite by also incorporating breach of contract into the analysis.

While Goldberg (1988) also fails to consider the costs of excuse, he proposes a basis forexcuse that is unrelated to relative risk aversion. Goldberg weighs the costs of holdingpromisors to agreements with the costs of releasing them. If the costs of holding apromisor to an agreement exceed the cost of release, the court should excuse performance.The costs of holding a promisor to an agreement result from the cost of monitoring thereasonableness of the promisee’s demands for substitute performance (that is, moral haz-ard costs). Because of full insurance, the promisee has no incentive to choose the mostefficient substitute.

But in order for substitute performance to cause a moral hazard problem, the promisormust be physically unable to perform. Otherwise, the court does not need to judge the rea-sonableness of substitute performance. Thus, moral hazard costs are not incurred if per-formance is simply commercially impracticable or if the purpose of the agreement is frus-trated.

3. The costs and benefits of contract excuse

3.1. The costs of performance excuse

If courts use discretion to decide cases, the costs of deciding performance excuse caseswill vary directly with the value of the contested performance. Under the current com-mercial impracticability and frustration of purpose rules, courts use discretion because therules condition excuse based on nonobservable factors (such as foreseeability). Forinstance, commercial impracticability under the Uniform Commercial Code allows excuseif “performance as agreed has become impracticable by the occurrence of a contingency,the non-occurrence of which was a basic assumption on which the contract was made.”8

But the court must not only make a discretionary decision about what is impracticable, itmust also make other discretionary decisions about foreseeability and indirect assumptionof risk.9

Similarly, courts must make a discretionary decision under the doctrine of frustration ofpurpose and the proposed doctrines based on relative risk characteristics in the impossibil-ity literature (Posner and Rosenfield, 1977; Perloff, 1981; Bruce, 1982; White, 1988; Sykes,

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1990). A contractor may plead frustration of purpose if an implied condition of the agree-ment does not occur or ceases to exist without the fault of either party and the absence ofthe implied condition “frustrates” one party’s intentions in agreeing to the contract.10

Implied conditions and “frustrated” intentions are by their very nature debatable. Under theproposed doctrines, a promisor may gain excuse if the court decides that the promisee is thesuperior risk bearer. But as Posner and Rosenfield (1977) concede, excuse under such a rulerequires that judges use discretion to infer a conclusion from economic evidence.

In deciding a case for excuse, the court essentially awards a sum equal to the value ofperformance—the difference between the market price and the contract price. Because thecourt uses discretion under all of the above legal rules, the contractors will spend resourcesto influence the outcome. Tullock (1967) notes that producers will invest resources in lob-bying for a tariff until the expected marginal benefit on the last dollar spent lobbying isequal to the marginal costs. The lobbying expenditures are pure social waste and the mag-nitude of the waste is directly related to the expected gains from the tariff.

Awarding a tariff is analytically the same as awarding either release from the obligationto perform or the right to force performance. Accordingly, the costs of determiningwhether the conditions established for excuse are met will be directly related to the valueof performance. That is, the contractors will consume real resources in an attempt to gainthe rents. We can expect that contractors will spend each dollar that increases expectedreturns more than that dollar. Contractors will always spend each additional dollar in a waythat maximizes their probability of prevailing at trial. This requires that they first completethe tasks that have the greatest positive effect on their probability of winning. An increasein the stakes implies that additional tasks will have expected returns that are greater thantheir costs. Thus, the amount of resources consumed in the attempt to gain the rents is adirect function of the value of performance.11

Although there is no way to tell precisely what this function may look like, a significantportion of the stakes will be dissipated in legal maneuvering. Tullock (1980) shows thatunder certain behavioral assumptions the directly unproductive profit-seeking (DUP)expenditures may exceed the rents at stake. Moreover, the structure of the institutions alsopoints to excessive DUP expenditures. Congleton (1980) shows that rules providing forall-or-nothing payoffs will promote more social waste than rules that reward each agentproportionally.

Because the value of performance essentially determines the cost of reallocating theburden of the contingency, models that assume a constant value of performance are fun-damentally flawed. A rational contractor will not spend valuable resources on litigation toprotect a right that has no market value. For instance, a contract may specify that apromisor must supply good A at $10 per unit. If a contingency occurs that drasticallyincreases the promisor’s cost of performance, the promisee will not litigate if substituteperformance is available for $10 per unit of good A. Yet both White (1988) and Sykes(1990) assume that the contingency does not change the value of performance. Cases inwhich the value of performance does not rise along with costs of performance typically donot reach trial. Interestingly, the cases that Sykes reviews confirm this (Sykes, 1990, pp.73–90). In each of the decisions he examines, the value of performance rises right alongwith the cost of performance.

DECISION COSTS, CONTRACT EXCUSE, AND IMPRACTICABILITY 45

3.2. The benefits of performance excuse

The contract with the highest social value uses the best information ex ante to allocaterights and responsibilities under the contract for the appropriate price (Posner andRosenfield, 1977; Goldberg, 1988; Sykes, 1990).12 Suppose, for instance, that promisorsmust bear the risk for all possible contingencies. Promisees may, in turn, agree to bear therisk for certain contingencies in return for a lower contract price. Thus, the parties will addclauses that allocate the risk toward the promisee in return for a lower price if the promiseecan self-insure or obtain insurance at rates lower than the price reduction.

If a contingency occurs and the contract does not explicitly specify the parties’ obliga-tions for such a contingency, a party to the contract may seek excuse. The court’s ex postintervention is valuable if it affects the ex ante expectations of the parties. Knowledge thatthe court will intervene to correctly allocate the burden of the contingency ex post willincrease contract values ex ante. Accordingly, any benefits from reallocating the burden ofthe contingency must exist at contract initiation. To maximize the joint value of the con-tract, the courts must consider the way in which the parties would have allocated the costof the contingency at contract initiation (Posner and Rosenfield, 1977; Perloff, 1981;Bruce, 1982; Goldberg, 1988; White, 1988; Sykes, 1990). I will show that these benefitsdepend on a number of factors, none of which are related to the value of performance.

To consider the benefits of contract clauses, we must examine the reasons that con-tracting parties may fail to include a particular clause in a contract. A contract may fail tospecify the obligations of the parties for four reasons: (1) both contractors judged the prob-ability of the event to be so small that it did not warrant the cost of negotiating a clausespecifying obligations; (2) the contractors failed to even consider the possibility of such acontingency; (3) one of the contractors was aware of the possibility of a certain contin-gency but did not alert the other party; and (4) to specify such a clause would expose oneof the parties to strategic-behavior risk.13

But the benefits to the court’s ex post intervention are likely to be small. More impor-tant, the benefits will not vary with the value of performance. In the first case, the con-tractors do not negotiate a clause covering the contingency because of the cost. Courtintervention provides benefits if courts supply the terms (ex post) that the parties foundtoo costly to negotiate. But these benefits are not related to the value of performance. Atcontract initiation, the contractors will add terms until the expected benefit of an addi-tional term equals the cost of negotiating an additional term.

Figure 1 shows a marginal benefit (MB0) schedule that arranges possible contractualclauses from highest to lowest expected benefit. The expected benefits of additional claus-es depend on the probability that the contingency will occur, the cost of the contingencywhen it does occur, and the differential ability of the parties to bear risk. In large com-mercial contracts, contingencies are often more costly and the marginal expected benefitsof the individual contractual clauses rise (MB1). But changes in the value of the contractand the cost of a contingency do not change the cost of negotiating additional clauses(MC). The marginal cost of adding terms will depend largely on the opportunity cost ofthe lawyer’s time. Because the expected benefits of the last clause always equal the mar-ginal cost, contracts that involve higher stakes will contain more contractual clauses,

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ceteris parabus (Y1 > Y0). However, the expected benefit of the last clause added will bethe same across agreements. Therefore, we can expect that (1) the expected benefits ofindividual clauses that do not appear in the agreement must be less than the marginal costof the lawyer’s time; and (2) the expected benefits of court intervention are independentof the value of performance.

In the second case, the contractors fail to even consider the possibility of the contin-gency. If the contractors do not consider the possibility of the contingency, the estimatesof the value of the contract are completely unaffected by the court intervention. If theevent is truly unforeseeable, the functions of insurance and risk bearing break down.Trimarchi (1991) argues that extraordinary and unforeseeable events that affect large sec-tions of society do not allow the principle of insurance to operate. Assigning the risk ofthese events will not in any way affect the probability that the event occurs. Placing therisk of the contingency on the “superior insurer” will not affect ex ante contract valueseither. The principle of insurance requires the contractor to aggregate a number of homo-geneous and uncorrelated risks. In order to reduce overall risk, the individual risks mustexhibit a statistical regularity. Otherwise, losses in a given timespan are not predictablewith a reasonable degree of accuracy. We can therefore expect that there will be no gainsto reallocating the burden of a contingency.14

In the third case, a contractor with superior information takes advantage of the otherparty. Here, the possibility of excuse will be ineffective as a means to force betterinformed parties to reveal what they know. For instance, a buyer with superior information

DECISION COSTS, CONTRACT EXCUSE, AND IMPRACTICABILITY 47

Figure 1.

about risks may conceal the information to receive a lower contract price.15 Buyers andsellers may complete exchanges for which there are no net benefits. A performance excusecould, in theory, alleviate this problem. The threat of releasing sellers from their obligationwhen buyers conceal risks would force buyers to reveal their knowledge about possiblerisks. However, such a threat will be ineffective. Better-informed buyers will react to thethreat by simply specifying a clause in the contract that explicitly allocates the risk of thecontingency to the seller.

Finally, the parties may fail to specify a clause because it exposes one of them to strate-gic-behavior risk. Court intervention to specify such a clause can provide no benefits andmay entail substantial costs. If courts read such clauses into agreements, they expose oneor both of the contractors to the strategic-behavior risk they originally sought to avoid. Theexposure will decrease the value of the contract.

In sum, the cost of determining whether the conditions are met rises monotonically withthe value of performance. The court, in deciding a case for excuse, gives away a valuableright. The litigants will spend more as the value of that right increases. In contrast, the ben-efits of court intervention are unrelated to the value of performance. The benefits of courtintervention to allocate the burden of a contingency (excuse performance) may be char-acterized as a random variable that is uncorrelated with the value of performance and withan upper bound of the opportunity cost of the lawyers’ time to write the particular clauseto allocate the burden.

As the value of performance increases, the case for allowing performance excusebecomes weaker. An increase in the value of performance increases the probability that thecosts of court intervention (determining whether the conditions for excuse are met) exceedthe expected benefits of court intervention (supplying the appropriate clause). If the valueof the contested performance is large, courts should not permit excuse under commercialimpracticability, frustration of purpose or any of the rules proposed in the literature whichcondition excuse on nonobservable factors. Thus, the strongest case for allowing excuseoccurs when (1) the value of the contested performance is small, (2) the parties to the con-tract could have contemplated the possibility of the contingency, and (3) they did not allo-cate the burden of the contingency because of the costs of negotiation.

4. Analysis of the Westinghouse commercial impracticability case

The facts of the Westinghouse case are available elsewhere, and I will not repeat them here(Joskow, 1977; Yokell and DeSalvo, 1985; Vandegrift, 1993). I do, however, wish to high-light several aspects of the case that pertain to my argument. First, the commercial imprac-ticability defense caused high expenditures but few if any benefits. Second, performanceexcuses are an inefficient tool to force contractors to mitigate damages. Third, the possi-bility of bankruptcy even in the absence of performance excuse is slim.

The DUP expenditures in the Westinghouse case were the result of the enormous stakescreated by the possibility of excusing performance on contracts for supply of about $2 bil-lion worth of uranium and the uncertainty associated with legal rules that rely on nonob-servable factors. It is impossible to determine the exact amount of DUP expenditures

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caused by the possibility of excuse under the commercial impracticability defense.Adjusting to the shock of higher uranium prices clearly requires renegotiation of contrac-tual terms. Renegotiation is costly. Thus, the contractors may incur adjustment costs underany legal regime. An honest measure of the costs of court intervention must include onlythe costs over and above the adjustment costs in the absence of court intervention.

Despite the measurement difficulties, there is clear evidence that the costs of court inter-vention are substantial and that the costs increase with the value of performance. Courtintervention is costly for two reasons. First, the possibility of a court-imposed solutionoften slows the negotiation process. Negotiations between the disputants would have pro-ceeded at a faster pace if the allocation of rights and responsibilities were certain.Uncertainty about how the court would decide, therefore, made bargaining more difficult.Second, the possibility of excuse caused Westinghouse and the utilities to collect, process,and present information that would be useless in private-party negotiations.

Although a performance excuse as ill-defined as commercial impracticability does notdecrease uncertainty, the courts often made the situation worse. For instance, in the wakeof the settlements reached in the Pennsylvania trial, the judge made comments that seemedto suggest Westinghouse might be excused from performing the contracts in the upcom-ing trial in Richmond federal court. “Westinghouse introduced extremely persuasive com-petent evidence…[that] a number of interrelated contingencies rendered performance ofthe asserted contracts commercially impracticable” (Wall Street Journal, 1977a). But thejudge countered that “Westinghouse owed [the utilities] a continuing fiduciary obligationto insure” (Wall Street Journal, 1977a). Such statements would explain at least in part whythere was not another settlement until the federal trial began in Richmond six months later.The judge in the federal case made similar errors. He declared during the proceedings that“nobody has a locked case on this litigation” (Wall Street Journal, 1977c).

The commercial-impracticability defense provided incentives for public posturing thatwere costly and did little to help the private negotiations. The Texas Utilities Services Inc.(TUSI) settlement is instructive in this regard. When the settlement negotiations betweenWestinghouse and TUSI finally commenced, the atmosphere was workmanlike and con-structive, (Wall Street Journal, 1977b). But as the companies quietly negotiated, the pub-lic pronouncements of Westinghouse remained strident. Westinghouse continued to insistpublicly that the court should excuse performance. Public efforts to portray the conse-quences of the uranium cartel and the uranium enrichment policies of the AEC as unfore-seen persisted.

In light of the uncertain legal regime, the economic rationale for such maneuvers isclear. The efforts represent an attempt not only to influence the court but also to influencethe expectations of the other party. Sometimes, of course, the efforts backfire, and the dis-putants move further apart. Individual pieces of evidence may be interpreted differently.Westinghouse spent large sums gathering evidence on an international uranium cartel.Westinghouse gathered the information not only to strengthen its case for excuse but tochange the expectations of the utilities. To the degree that Westinghouse was successful,the utilities settled for less.

Information acquisition went far beyond anything necessary for private negotiations.Perhaps the largest expenditure was the Westinghouse antitrust suit against uranium pro-

DECISION COSTS, CONTRACT EXCUSE, AND IMPRACTICABILITY 49

ducers. In 1976, Westinghouse virtually ignored the possibility of settling cases, as thecompany concentrated almost completely on compiling information on the internationaluranium cartel to strengthen its case for excuse. (Wall Street Journal, 1978). It was nosecret that Westinghouse hoped the price-fixing charges would strengthen its case forexcuse (Wall Street Journal, 1979). The utilities, on the other hand, investigated whatWestinghouse knew about the shortage of uranium and when they knew it (Wall StreetJournal, 1978).

Damages that result from a failure to perform may be reduced by the actions of the con-tractors. Efficiency requires that the contractors take any actions that cost less that themarginal reduction in damages. Bruce (1982) and Sykes (1990) claim that performanceexcuses are an effective tool to force promisees to mitigate damages. Because of the pos-sibility of excuse, a promisee has an incentive to make the efficient amount of relianceexpenditures.

While this may be true, any gains from efficient reliance by promisees must be weighedagainst increased damages from attempts by promisors to conceal the effects of the con-tingency. Promisors have incentives to allow the effects of a contingency to worsen inorder to strengthen their case for excuse. The chairman of Westinghouse (Robert Kirby)maintained that the board did not know about the short position in uranium untilSeptember of 1974 (Wall Street Journal, 1976b). By that time, the problem was too largeto solve. Kirby admitted that he had heard whispers about the short position in 1974 butthat he wasn’t “really aware” of the problem until the board meeting in September. Therevelations led to a quest to determine what the chairman of Westinghouse knew and whenhe knew it.

Aside from the problem of determining who had to know what (the board or Kirby) andwhen the information would have allowed the corporation to avert the problem, commer-cial impracticability gives perverse incentives regarding the flow of information inside thefirm regarding risky ventures. If the board or the chair is unaware of the risky ventures ofsubordinates, the firm may escape the consequences of the risk yet retain the payoff. Thus,the firm may keep the chain of command unclear or reduce the flow of information toupper-level decision-makers if the law allows excuse under commercial impracticability.

Trimarchi (1991) uses the possibility of bankruptcy as a justification for excuse. Heargues that excusing performance under commercial impracticability avoids the reorgani-zation costs associated with bankruptcy. But the expected costs of bankruptcy are over-stated. The utilities had no incentive to force Westinghouse into bankruptcy. A bankruptWestinghouse would surely decrease the payoff to the utilities. The payoff would fall fortwo reasons.16 First, a solvent Westinghouse would be able to make settlement paymentsover a number of years. Second, the utilities owned large amounts of Westinghouse equip-ment. Repair and modification would be difficult or impossible if the specialized knowl-edge that Westinghouse had was no longer available.

Westinghouse did not need court intervention to avoid bankruptcy. A promisor will notnecessarily perform simply because the court does not excuse (Ulen, 1984; Friedmann,1989). Even though Westinghouse was eventually denied excuse, the company did not ful-fill the letter of the remaining outstanding contracts. Clearly, the utilities moderated theirdemands to ensure that Westinghouse remained a viable entity. The total cost to

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Westinghouse of settling all the uranium supply contracts was only about 40 percent ofactual damages (expectation) (Wall Street Journal, 1981). The utilities reduced theirdemands not out of altruism but out of self-interest. A financially healthy Westinghousewould be able to confer benefits over a number of years. Indeed, each of the settlementsprovided for Westinghouse to supply the utility with equipment, services, or discounts ata future date (Yokell and DeSalvo, 1985).

5. Conclusion

The requirements that the promisor must meet to qualify for excuse under frustration ofpurpose or commercial impracticability are not observable. Because judges cannotobserve whether the conditions for excuse are met, opportunistic contractors will attemptto exploit the uncertainty created by performance excuses to increase their gains or reducetheir losses under the contract.

Alternative performance excuse proposals in the law and economics literature sufferfrom similar disabilities. In the attempt to outline conditions for excuse that will maximizethe joint value of contracts, they do not consider the costs of determining whether the con-ditions for excuse are met. Although the proposals differ substantially from the laws nowin place, either would rely on the courts to make decisions based on criteria that are notobservable (for example, superior risk bearer). In relying on nonobservable criteria, theproposals also create uncertainty and strategic behavior.

Because of uncertainty and strategic behavior, deciding contract excuse cases is costly.The cost of deciding contract excuse cases rises with the value of performance. The law,in essence, awards a sum equal to the value of performance. We can expect that contrac-tors will spend each dollar that increases expected returns more than that dollar. Thus, theamount of resources consumed in the attempt to gain the rents is a direct function of thevalue of performance. In contrast, the benefits of contract excuse (1) never exceed theopportunity cost of the lawyers’ time to write the particular clause to allocate the burdenand (2) are uncorrelated with the value of performance. Consequently, the case for per-formance excuses is strongest when the value of performance is small. If the value of per-formance is large, the net benefits of contract excuse are negative.

A review of the Westinghouse commercial impracticability case shows the legal maneu-vering caused by the possibility of excuse. Moreover, the case illustrates a number of addi-tional points. First, private-party negotiations are faster and more effective than court order-ing. Second, the promisee rarely has an incentive to drive the promisor into bankruptcy.Third, performance excuses are an inefficient tool to force contractors to mitigate damages.

Acknowledgments

Tom Miceli, Richard Langlois, Mwangi S. Kimenyi, Scott Sumner, William Shughart,John Leeth, Paul Brown, and two anonymous referees provided helpful comments on ear-lier drafts. I am responsible for any errors that remain.

DECISION COSTS, CONTRACT EXCUSE, AND IMPRACTICABILITY 51

Notes

1. Directly unproductive profit-seeking (DUP) is a more precise term for what is commonly referred to as rent-seeking. See Bhagwati (1982).

2. Kaplow (1992) develops an analysis that considers decision costs in the context of tort. But he admits thatbackground laws raise different issues and would require another framework. See also Ehrlich and Posner(1974).

3. We may define the value of performance as the market price of performance less the contractually specifiedprice of performance.

4. I will not consider here the possible public good benefits of court excuse. For instance, a court decision maygive guidance to a group of similarly situated parties on how to design their affairs. Of course, private agree-ments between some of the parties may also have public-good benefits. Parties to a dispute are more likelyto discover previous court decisions. However, settlement agreements, because they are voluntary, are likelyto be more efficient than court-imposed solutions. Indeed, many of the later settlements in the Westinghousecase simply adopted the framework of the earlier settlements rather than the court-imposed solution. (see WallStreet Journal, 1978). Finally, I note that vague laws often create opportunities for public-good benefits.Court decisions that clarify vague laws have public-good benefits. But rather than issuing court decisions, weought to simply write laws that are less vague.

5. This supports Williamson’s contention that negotiations proceed faster in a more informal setting (seeWilliamson 1985).

6. Trimarchi (1991) argues that the possibility of bankruptcy is a basis for excuse.7. Bruce (1982) and Sykes (1990) argue that performance excuses are an effective tool to force contractors to

mitigate damages. Evidence from the Westinghouse case indicates that the opposite may occur. The presenceof a performance excuse may cause one of the contractors to engage in behavior that would increase the levelof damages.

8. Uniform Commercial Code section 2-615.9. From the text of the Uniform Commercial Code and the official comments, Joskow (1977) distills six con-

ditions that must be met to excuse performance under commercial impracticability: (1) a failure of the under-lying contract must occur; (2) the failure must have been unforeseen at the time the contract was signed; (3)the failure must not have been assumed either directly or indirectly by the party seeking excuse; (4) perfor-mance must be impracticable; (5) the seller must have made all reasonable attempt to assure himself that thesource of supply will not fail; and (6) the seller’s own conduct must not have created the situation leading tothe impracticability of performance.

10. The leading case here is Krell v. Henry, L.R. 2 K.B. 740 (1903).11. Field studies confirm this theoretical proposition. In an analysis of highway collisions involving live-

stock, Ellickson (1991) notes that the quantity of legal and factual research pertinent to a claim increas-es with the amount at stake. Ross (1980) makes a similar observation in a study of automobile insuranceadjusting.

12. If we discover ex post that the “wrong” party is responsible for the costs of a contingency, then we can expectthat because transactions costs are low (the parties know each other) and property rights are well defined, thepromisor and promisee will strike a deal that makes both better off (Coase, 1960). A costly court-imposedsolution is unnecessary. Incidentally, such exchanges will occur regardless of whether the burden of the con-tingency has been allocated explicitly in the agreement or by default.

13. Schwartz (1992) and Spier (1992) provide a detailed explanation of strategic-behavior risk and its effect oncontracts.

14. Even if we assume that the functions of risk bearing and insurance continue to operate, the gains to excuseare unlikely to increase with the value of performance. The benefits of reallocating the burden of the contin-gency are a function of the relative risk-bearing capacities of the parties. Large commercial contractors areunlikely to have risk-bearing capacities that differ by very much.

15. Sellers with superior information about risks have an incentive to communicate the information if the infor-mation raises price at contract initiation. That is, if the seller knows that risk is higher than the buyer believes,the seller will communicate the information to obtain a higher contract price. If the seller knows that the riskis lower than the buyer believes, the seller will not communicate the information. Nevertheless, the threat of

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contract excuse will not force the seller to communicate this information. Buyers with superior informationabout risk will communicate the information only if they know that the risk is lower than the seller believes.Communicating the information lowers the price that buyers must pay. Consequently, we need only considerthe case in which a better informed buyer knows the risk is higher than the seller believes.

16. At the outset, shrewd industry analysts suspected that the utilities would settle out of court for something lessthan the contracts required (see Wall Street Journal, 1976a).

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