Precontractual liability and preliminary agreements

Abstract

For decades, there has been substantial uncertainty regarding when the law will impose precontractual liability. The confusion is partly due to scholars' failure to recover the law in action governing precontractual liability issues. In this Article, Professors Schwartz and Scott show first that no liability attaches for representations made during preliminary negotiations. Courts have divided, however, over the question of liability when parties make reliance investments following a "preliminary agreement." A number of modern courts impose a duty to bargain in good faith on the party wishing to exit such an agreement. Substantial uncertainty remains, however, regarding when this duty attaches and what the duty entails. Professors Schwartz and Scott develop a model showing that parties create preliminary agreements rather than complete contracts when their project can take a number of forms and the parties are unsure which form will maximize profits. A preliminary agreement allocates investment tasks between the parties, specifies investment timing, and commits the parties only to pursue a profitable project. Parties sink costs in the project because investment accelerates the realization of returns and illuminates whether any of the possible project types would be profitable to pursue. A party to a preliminary agreement "breaches" when it delays its investment beyond the time the agreement specifies. Delay will save costs for this party if no project turns out to be profitable and will improve this party's bargaining power in any negotiation to a complete contract. Delay often disadvantages the promisee, and when parties anticipate such strategic behavior, they are less likely to make preliminary agreements. This disincentive is unfortunate because a preliminary agreement often is a necessary condition to the realization of a socially efficient opportunity. Thus, contract law should encourage relation-specific investments in preliminary agreements by awarding the promisee his verifiable reliance if the promisor has strategically delayed investment. Professors Schwartz and Scott study a large sample of appellate cases showing that: (1) parties appear to make the preliminary agreements described in the model and breach for the reasons the model identifies, and (2) courts sometimes protect the promisee's reliance interest when they should, but the courts' imperfect understanding of the parties' behavior sometimes leads them to err. I. INTRODUCTION For at least fifty years, a particular pattern of commercial behavior has engendered considerable litigation and substantial scholarly commentary. Two commercial parties agree to attempt a transaction and agree also on the nature of their respective contributions, but neither the transaction nor what the parties are to do is precisely described, and neither may be written down. The parties do not agree and, indeed, may never have attempted to agree on important terms such as the price. After the parties agree upon what they can, and before uncertainty is resolved, one or both of them make a sunk-cost investment. (1) This pattern of commercial behavior suggests that the parties have made a "preliminary agreement" that will have one of two legally significant outcomes: If the transaction turns out to be profitable after uncertainty is resolved, the parties will make their agreement more concrete and then conduct the transaction. But if the transaction turns out to be unprofitable, the parties will abandon the project. Disputes sometimes arise under these preliminary agreements after one or both of the parties have invested. One party may then abandon the project even though the other party protests the first party's exit. In particular, the disappointed party believes that he is entitled to compensation either for his expectation or for his investment cost while the other party believes that she is entitled to exit without liability. A court must then decide whether to protect the promisee's (2) expectation interest, or to protect his reliance interest by reimbursing his sunk cost, or to award him nothing. …