EFFICIENT BREACH — the conceptual opposite of PACTA SUNT SERVANDA

What is an “efficient breach”? An efficient breach is a concept from the philosophy of law that claims the superiority of mammon over morality. A concept derived from the economic analysis of law, which undermines the Latin principle pacta sunt servanda – agreements must be kept – engraved in the minds of Polish lawyers, which is one of the most important structural elements of Polish civil law.

It also provides an excellent illustration of the differences in the continental and Anglo-Saxon (and in this case mainly American) legal systems but simultaneously shows how these systems interact.

An efficient breach is also a terminological challenge for Polish lawyers and translators when translating this concept into Polish. For this reason, I decided to write a few words about it and refer to the scarce Polish legal texts that mention this concept.

Let’s start with a definition from Black’s Law Dictionary 10th Edition:

Efficient breach theory – The view that a party should be allowed to breach a contract and pay damages, if doing so would be more economically efficient than performing under the contract. This relatively modern theory stems from the law-and-economics movement.

Efficient breach – An intentional breach of contract and payment of damages by a party who would incur a greater economic loss by performing under the contract.

 

The economic approach in the philosophy of law, from which the concept described is rooted, considers efficiency to be the primary value-driving contract law. The requirement to meet obligations which have been contracted is, according to this approach, one of the most important guarantees of the functioning of a market economy. This, in turn, is one of the most effective tools for ensuring an increase in social welfare, and therefore also in the individual welfare of those involved in market exchanges. Representatives of economic theory take a view similar to that of the realists on the nature of contractual obligations undermining the principle requiring them to be kept, with very few exceptions, which follows from pacta sunt servanda principle. In line with this approach, by entering into a contract, we undertake either to perform its terms or to pay adequate compensation, either of these two options constituting proper performance of our obligations. This argument forms the basis for the efficient breach theory, which is popular among economically motivated researchers and which lies at the core of this article. Following this theory, an entity that has entered into one contract, thereby depriving itself of the opportunity to enter into another, more profitable one, is entitled, or even obliged, to breach the provisions of the first contract, pay appropriate compensation, and enter into another one[1].

The professional literature indicates that the concept of “efficient breach” appeared in R.L. Birmingham’s article, Breach of Contract, Damage Measures, and Economic Efficiency, Rutgers Law Review 1970, vol. 24, pp. 284 et seq, and Ch.J. Goetz and R.E. Scott named the theory, Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach, Columbia Law Review 1977/4, p. 554. It is closely associated with R. Posner, who articulated its tenets in support of Lake River Corp. v. Carborundum Co., 769 F.2d 1284 (7th Cir. 1985) (expressing the majority opinion)[2].

It is often argued that the inspiration for the theory of “efficient breach” came from the well-known words of O.W. Holmes Jr., The Path of the Law [in:] The Collected Legal Papers, New York 1920, p. 175: “The only universal consequence of a legally binding promise is that the law makes the promisor pay damages if the promised event does not come to pass. In every case it leaves him free from interference until the time for fulfilment has gone by, and therefore free to break his contract if he chooses”[3].

It would be useful to clarify what is meant by an efficient breach of contract. In the simplest terms, we can say that when a breach is more profitable for both parties than performance, we can speak of an efficient breach – this understanding of the concept of efficiency of breach of contract can be described as a global approach.

However, in the reality of economic transactions, the presented approach is receding into the background, and the most important role is given to particular interests of each of the participants of this transaction; in this case, we can talk about an individual approach to the concept of efficient breach of contract. In this context, the debtor’s decision whether or not to perform will be determined primarily by cost and liability factors.

Efficient breach of contract in an individual approach does not necessarily preclude the occurrence of an efficient breach of contract in a global approach as well. The essence of this issue is that liability for breach of contract is set at such a level that breach thereof will only be profitable for the debtor if a global assessment of the performance of such a contract also shows that breach thereof is efficient for all parties to the contract[4].

Such an approach to contractual obligations is unknown to Polish legal thought, as it contradicts the principle of the durability of a contractual relationship (Latin: pacta sunt servanda) resulting from the Roman and, more broadly, continental tradition, which was indirectly expressed in Articles 354 and 355 of the Polish Civil Code. Pursuant to these provisions, the debtor shall perform the obligation in accordance with its content and in a manner corresponding to its social and economic purpose and the principles of social co-existence, and if there are established customs in this respect, also in a manner corresponding to these customs. In the same way, the creditor shall cooperate in the performance of the obligation. The debtor is also obliged to exercise the diligence generally required in relations of a given type (so-called due diligence). The due diligence of the debtor in the course of their economic activity shall be determined having regard to the professional nature of that activity. The above principle is complemented by Article 3581(3) of the Polish Civil Code, according to which in the case of a material change of the purchasing power of money after the obligation has arisen, the court may, after considering the interests of the parties and in accordance with the principles of social co-existence, change the amount or the manner in which pecuniary performance should be rendered even if the same has been specified in the decision or the contract.

Naturally, the principle of the durability of contractual obligations is not absolute, and there are exceptions in Polish civil law giving the parties the possibility to modify or cancel the contract (e.g. Article 3571 of the Polish Civil Code – extraordinary change of circumstances, Article 632(2) of the Polish Civil Code – the risk of glaring loss). However, as it has been mentioned, these are exceptions to the general principle, which are additionally subject to a very restrictive interpretation and require court intervention.

The legal instruments known to the Polish legal system that are functionally similar to the idea of efficient breach of contract include the contractual right of withdrawal used in combination with the payment of compensation for withdrawal from/termination/renunciation of contract or payment of earnest money.

The stipulation concerning the compensation for withdrawal from the contract (Article 396 of the Polish Civil Code) is a modification of the withdrawal clause (Article 395 of the Polish Civil Code). No statutory right of withdrawal or termination may be introduced. It gives a party the right to cancel the effects of an effectively concluded binding contract within a certain period of time by making a declaration of intent accompanied by the payment of a sum of money as a surrogate for compensation for loss of contract. This stipulation is aimed to reduce the impairment of the contract caused by the contractual right of withdrawal. It makes the withdrawal by one party conditional on the payment of compensation to the other party. The provisions on the contractual right of withdrawal (Article 395 of the Polish Civil Code) shall apply to the withdrawal provision, with the difference that the payment of compensation shall be made simultaneously as the declaration of withdrawal[5].

A party’s declaration of withdrawal is effective if, at the same time as, or previously (a fortiori request), compensation has been paid. A declaration made without the payment of compensation is ineffective, but another declaration, accompanied by the payment of a sum of money, may be made.

In the broad sense of the term given at the conclusion of the contract, the parties may give earnest money the legal status of compensation if they stipulate that the contract may be withdrawn with the loss of the earnest money or with the payment of double earnest money.

From an axiological and structural perspective, the above instruments differ fundamentally from an “efficient breach of contract” as they are contractual rights of the parties introduced into the contract with the parties’ consent and exercised within strictly defined limits (primarily time limits). In other words, these instruments are used under contract, and they are contractual clauses.

To demonstrate the axiological incompatibility of the “economic” approach to the durability of contractual obligations with the Polish legal system, it is worth recalling the content of Article 483(2) of the Polish Civil Code: “The debtor cannot, without the creditor’s consent, release himself from the obligation by payment of liquidated damages[6]”. This provision unambiguously expresses the prohibition of unilateral release from an obligation by the payment of liquidated damages (including those stipulated in the event of withdrawal from the contract). A similar idea is reflected in Article 480 of the Polish Civil Code, which grants the creditor the right to demand that the court authorise the performance of the act at the debtor’s expense in the event of the debtor’s delay in performing an obligation, irrespective of the right to claim compensation in this respect.

As stated in the reasons for the judgment of the Court of Appeal in Kraków dated 24 May 2016 (I ACa 218/16): “It does not seem reasonable to seek in Article 483(1) of the Polish Civil Code a provision making a claim for payment of liquidated damages contingent on the fact that the damage has occurred or increased. A causal link between the sanction in the form of liquidated damages and the creditor’s loss is also broken. It seems that a breach of the pacta sunt servanda principle is a sufficient circumstance to defend an argument that liquidated damages are justified if stipulated in the event of non-performance or improper performance of the contract. Liquidated damages are intended to remedy all the consequences that arise from the non-performance of an obligation in respect of the creditor’s interests. In view of the autonomy of the parties’ wills, the reasons for which the liquidated damages have been stipulated may be intended to satisfy any interest known only to the creditor. The creditor is obliged to prove the damage when attempting to seek compensation for the breach of the contractual relationship pursuing claims under general principles of civil law, pursuant to Article 471 of the Polish Civil Code.”

The right to compensation for non-performance and the liquidated damages as its surrogate were introduced as instruments to guarantee the durability of contractual obligations and to protect the creditor’s interest. Under no circumstances may their payment be considered equivalent to the performance of an obligation in kind or release the debtor from far-reaching consequences (e.g. criminal charges or tendering ban).

However, the theory of the efficiency of contractual obligations, originating in US law, derives from a different approach. It is based on the assumption that individuals let themselves be guided by laws that induce actions that are designed to maximise material gain. The most distinctive fruit of the efficiency theory is precisely the “efficient breach of contract” concept, which assumes that the economic priority of assessing the efficiency of a contract should result in the possibility of a deliberate breach of contract coupled with the payment of compensation, if, in the overall settlement of the parties, it proves to be more economically efficient than if the contract had been performed (i.e. the overall profit of all parties involved will be greater in the case of a breach of contract than in the case of its performance). Efficiency theory has suffered various criticisms, especially because of problematic issues arising from how it relates to the criterion of morality and transparency. As regards the first criterion, it is debatable to consider that the theory itself is based on the assumption that the actions of the contracting parties have a moral basis, when the theory can rather be considered as a tool for the breach of individual rights and freedoms, since it treats contracts, to some extent, as means to a specific goal. For the second criterion, however, it is essential to note that economic reasoning about contractual obligations is rather something outside contract law, it is just some kind of proposal of interpretation from outside using methods that are not typical for jurisprudence[7].

The will of the contracting parties is the fulfilment of specific needs, typically financial ones. The purpose of a contract consisting in the pursuit of the interests of the parties by means of a favourable exchange of a service for capital or capital for goods is the basis of civil law transactions. The interests of the parties at the time of the conclusion of the contract are usually different in substance but hardly ever opposite. As a rule, the parties decide to enter into a contract precisely because these interests are complementary. This is the case, in particular, for reciprocal contracts based on the principle of equal consideration of interests. Each party to the contract has an interest in the performance of the obligation. The role of private law is to create conditions for the existence and development of transactions by protecting this interest. Under the civil law regime of contractual liability, the creditor’s interest is to be satisfied with the debtor’s performance under the contractual terms. If the debtor fails to perform or improperly performs their obligations, the creditor is entitled to such remedies that intend to protect that interest.

The creditor’s interest in having their obligation satisfied is correlated with the debtor’s interest in satisfying that obligation. The debtor also remains subject to legal protection. Under a reciprocal contract, the debtor’s interest in performance arises primarily from its will to receive an equal performance from the other party. However, even the performance of an obligation by the other party to the contract does not cause the interest to become non-existent. The debtor still has an interest in the performance of their obligation because of the negative consequences if they fail to meet the performance under the contract[8].

Although this interest may be different in certain situations – if the comparison between the cost of performance and liability for non-performance shows that the debtor will benefit less from performance than from a loss due to non-performance, this may cause the debtor to lose their interest in performance[9].

In my view, one should agree that the fact that the creditor is entitled to a claim for the effective performance of the obligation determines, in and of itself, that the debtor will be more likely to perform than if the creditor is only entitled to a claim for compensation (for breach of an obligation not to terminate the contract). It seems reasonable to differentiate between two situations: where the debtor’s decision not to perform the agreed obligation is not the result of an economic calculation and where the debtor refuses to perform the obligation for economic reasons. In the former situation, it seems reasonable to assume that it is irrelevant for the debtor how the non-performance is classified. Regardless of this classification, a debtor that fails to act in a manner consistent with the agreed performance breaches an obligation (either an obligation under a contract giving rise to a continuing obligation or an obligation not to terminate such contract). As such, if it is sufficient motivation for a particular debtor to undertake this behaviour where the debtor knows that their refusal constitutes a breach of a legal obligation, this motivation is present regardless of what meaning is given to the contractual restriction on withdrawal. In turn, if the debtor has no moral reluctance to breach a legal obligation, the debtor will be inclined to refuse to undertake the agreed behaviour to the same extent, regardless of the legal classification of that refusal. When analysing the former situation, it must be assumed that the debtor would be inclined not to perform the agreed obligation when its non-performance would bring the debtor benefits exceeding the pecuniary loss suffered in this respect[10].

The common criticism of “immorality” alleged against the efficient breach theory and often against the entire economic analysis of law should be quoted here. This is because the aim of this theory is to induce individuals to act solely on the basis of economic criteria, disregarding other values. A dispute over whether it is moral to breach a contract for the sake of profit is often discussed. It is argued that economic efficiency cannot be the only criterion for law-making. The Constitution does not require the legislator to be motivated solely by this value. There are also other values, higher or at least equivalent, which the legal system should protect in different situations[11].

It is worth noting that the Polish and European legal academic circles present views allowing for the application of the “efficient breach of contract” concept in cases of economic impossibility or unreasonableness of performance, the occurrence of which would be a prerequisite for extinguishing the obligation relationship and releasing the debtor from the obligation to perform. In such situations we are dealing with an involuntary efficient breach of contract, as opposed to a deliberate efficient breach, which is the result of an anticipated, unreasonable, excessive burden of performance of the obligation in kind on the debtor, i.e. outlays for performance exceeds the debtor’s reasonable limits, and the expenses incurred by the debtor are much greater than the creditor’s potential benefit, which is the result of changes in the economic situation that are beyond the parties’s control[12].

Finally, it is worth mentioning a critical statement by a representative of international doctrine on the application of the concept on the basis of Article 74 of the United Nations Convention on Contracts for the International Sale of Goods:

 

Eicher, Florence (2018) Pacta Sunt Servanda: Contrasting Disgorgement Damages with Efficient Breaches under Article 74 CISG. LSE Law Review. pp. 29-43.

“According to the Secretariat Commentary to Article 74 CISG, the provision’s draft counterpart, draft Article 70, was clearly intended to convey the notion ‘that the basic philosophy of the action for damages is to place the injured party in the same economic position he would have been in if the contract had been performed.’ Therefore, damages should be assessed according to the expectation interest. It is suggested that discouraging parties from a deliberate breach of contract is, aside from the financial protection of the aggrieved party, the main motivation behind a damages clause. Article 74 CISG reflects the fact that pacta sunt servanda is one of the principles underlying the CISG, as it upholds a party’s right to performance and protects this right with the principle of full compensation. An adverse interpretation of Article 74 CISG would lead to an encouragement of the concept of efficient breach, which is adverse to and in direct conflict with both pacta sunt servanda and the principle of good faith enshrined in Article 7(1) CISG. (…)

Efficient breach builds upon the dual performance hypothesis, and operates under the premise that, in a contract, parties can choose to either fulfil their primary contractual obligations or pay damages. Thereafter, having compensated the aggrieved party for the breach, the surplus left can be kept by the breaching party. Advocates of this concept argue that it allows both parties to gain – the aggrieved party is put in the position it would have been in had the contract been duly performed, while the breaching party was able to make a larger profit. The opposing view highlights the importance of remedies such as specific performance and restitution in cases of contractual breach.”

This article is inspired by a terminology question posed a few months ago on one of the specialised translators’ discussion groups. I have chosen to use this case as a foretaste to illustrate how much additional knowledge and searching of sources is required from a translator of legal texts when attempting to properly understand the terminology of the source language and, at the same time, how dangerous it is to take shortcuts and how many traps are hidden by the incompatibility of legal systems.

 

Footnotes and literature:

[1] S. Osmola, Dlaczego umów należy dotrzymywać?, Filozofia w praktyce, vol. 4, 2018

[2] T. Targosz, 4. Osoby trzecie a umowa [in:] Qui bene dubitat, bene sciet. Księga jubileuszowa dedykowana Profesor Ewie Nowińskiej, ed. J. Barta, J. Chwalba, R. Markiewicz, P. Wasilewski, Warsaw 2018.

[3] ibid.

[4] M. Łolik, Efektywne niewykonanie kontraktu, PPH 2007, No. 12, pp. 44-50.

[5] Fras Mariusz (ed.), Habdas Magdalena (ed.), Kodeks cywilny. Komentarz. Tom III. Zobowiązania. Część ogólna (art. 353-534), Wolters Kluwer Polska 2018

[6] pl. kary umowne

[7] Piotr Alexandrowicz, Kanonistyczne uzasadnienie swobody umów w zachodniej tradycji prawnej. Doctoral dissertation, Adam Mickiewicz University, Poznań 2019.

[8] K. Pasko, I. UWAGI OGÓLNE [in:] Ochrona strony słabszej stosunku prawnego, ed. M. Boratyńska, Warsaw 2016.

[9] Cf. efficient breach of contract theory, M. Łolik, Efektywne niewykonanie kontraktu, PPH 2007, No 12, p. 44 et seq., in the foreign references cf. B. Medina, Renegotiation, Efficient Breach and Adjustment (in:) Comparative Remedies for Breach of Contract, ed. N. Cohen, E. McKendrick, Oxford and Portland, Oregon 2005, pp. 56 et seq. and also S. Rowan, Remedies for breach of contract. A Comparative Analysis of the Protection of Performance, New York 2012, p. 4 and the views cited therein.

[10] R. Strugała, Umowne ograniczenie prawa do wypowiedzenia bezterminowego zobowiązania o charakterze ciągłym. Uwagi na tle wyroku Sądu Najwyższego z 13 czerwca 2013 r. (V CSK 391/12), PS 2015, No. 4, pp. 62-78.

[11] I. Karasek-Wojciechowicz, Roszczenie o wykonanie zobowiązania z umowy zgodnie z jego treścią, LexisNexis 2014

[12] Cf.: P. Gorzko, Note to the judgment of the Supreme Court of 18 May 2011, III CSK 217/10.