“Over a barrel”: contract modification, reliance, and bankruptcy

International Review of Law and Economics 22 (2002) 41–51

“Over a barrel”: contract modification,reliance, and bankruptcy

Thomas J. Miceli∗

Department of Economics, University of Connecticut, 341Mansfield Road, Storrs, CT 06269, USA

Accepted 19 February 2002

1. Introduction

Contract modification refers to the adjustment of the terms of a contract, following theformation of the contract but prior to performance, in response to some change in the con-tracting environment. An important question in contract law concerns the enforceability ofmodifications. Traditionally, the law has required the party benefiting from the change to offernew consideration in order for it to be enforceable (the pre-existing duty rule). From the lawand economics perspective, however,Posner (1977, 1998, p. 111)notes that modificationslacking consideration should nevertheless be enforced when they are a response to a genuinechange in economic circumstances, as when a contractor obtains a price increase to coveran unexpected cost increase. In contrast, he argues, purely opportunistic or redistributionalchanges that simply reflect an increase in bargaining power by one of the parties should not beenforced.1 Posner cites the decisions inGoebel v. Linn2 (modification in response to a genuinechange enforced), andAlaska Packers’ Assn. v. Domenico3 (purely opportunistic modifica-tion not enforced) as evidence that courts seem to be sensitive to this distinction, despite thetraditional rule.

Taking the Posner rule as the starting point, this note examines the role of modification inpromoting both efficient breach by the promisor and efficient reliance by the promisee in theface of a cost increase that would bankrupt the promisor. The significance of the bankruptcythreat is that it leaves the promisee without a remedy (or with an inadequate one) in the event ofbreach, which can result in excessive breach. In this setting, it has been shown that modification

∗ Tel.: +1-860-486-5810; fax:+1-860-486-4463.E-mail address: [email protected] (T.J. Miceli).

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42 T.J. Miceli / International Review of Law and Economics 22 (2002) 41–51

can restore incentives for efficient breach, assuming that renegotiation is costless (Aivazian,Trebilcock, & Penny, 1984; Dnes, 1995).

What has not been addressed in the literature, however, is how enforcement of modificationin this context affects incentives for reliance by the promisee.4 It is well-known that theexpectation damage remedy creates incentives for over-reliance by promisees (in the absenceof a bankruptcy threat) because it fully insures promisees against the risk of nonperformance(Rogerson, 1984; Shavell, 1980). In contrast, one can show that bankruptcy (zero damages)in the event of breach leads to too little reliance because the probability of breach is greaterthan the efficient probability. (Reliance is efficient, however,conditional on the probability ofbreach.) The question is how modification affects incentives for reliance. There is a trade-off: onthe one hand, it should increase the promisee’s reliance by restoring the efficient probabilityof performance, but on the other, it may discourage the promisee from investing for fearthat the nonsalvageable nature of reliance will put him at a bargaining disadvantage shouldrenegotiation occur.

The latter problem is well-illustrated by the facts ofGoebel v. Linn. Plaintiff was a brewerwho contracted with an ice company to deliver ice during the summer. However, a warm winterresulted in a short supply of ice, so the ice company demanded a higher price as a conditionfor performance. Faced with loss of his beer, the plaintiff agreed to the price increase, but laterreneged on the ground that the price change had not been supported by additional consideration.The court nevertheless enforced the price increase based on evidence that the ice companylikely would have gone bankrupt if the original contract had been enforced.

Although there is no question that enforcement of a price increase promotes efficient per-formance in this case, the potential for opportunism remains regarding theamount of theincrease. In particular, note that the brewery was in a poor bargaining position because ofthe potential loss of its beer—i.e., one might argue that it hadoverrelied on performance byproducing too much beer, or by not arranging for other possible suppliers of ice. As a result,the ice company had the brewery “over a barrel” with regard to the price increase. I will showthat this threat actually creates an incentive for promisees tounderrely when they anticipate(1) that promisors will be bankrupt in the event of breach, and (2) that courts will enforcemodifications according to the Posner rule. Promisees have an incentive to underrely in thiscase to protect themselves from being exploited during renegotiation. However, I go on to showthat incentives for efficient reliance can be restored if, when courts enforce modifications, theylimit any price increase to the amount of the promisor’s costs increase.5 This “augmented”Posner rule simultaneously promotes efficient performance and reliance. A review of the lawof modification suggests that courts seem to follow this prescription.

The remainder of the paper is organized as follows.Section 2develops the theoretical analy-sis and derives the efficient modification rule.Section 3briefly reviews the law of modificationand relates it to the theoretical results. Finally,Section 4concludes.

2. The model

Consider a contract between a risk-neutral buyer and a risk-neutral seller–producer callingfor the delivery of a certain good.6 The dollar value of performance to the buyer isV(r), where

T.J. Miceli / International Review of Law and Economics 22 (2002) 41–51 43

r is the investment in reliance,V ′ > 0, V ′′ < 0, andP is the price to be paid on performance.The seller’s cost of performance,C, is a random variable whose value is only realized afterthe contract price is set. Initially, I assume that onceC is realized, it is public knowledge. Thisrules out the possibility of opportunistic renegotations by the seller. At the conclusion of thissection, I note the implications of allowing asymmetric information aboutC.

In this model, performance is efficient, givenr, if V (r) ≥ C, while breach is efficientif V (r) < C. Since we assume that reliance is chosen prior to the realization ofC and isnonsalvageable, the socially optimal choice ofr maximizes∫ V (r)

0[V (r) − C)] dF(C) − r, (1)

whereF(C) is the distribution function ofC. The resulting first-order condition is

F(V (r))V ′(r) = 1. (2)

Thus, optimal reliancer∗ equates the expected marginal benefit of performance to the marginalcost, whereF(V(r)) is the efficient probability of performance givenr.

It is well-known that an expectation damage remedy, which in this case is given byD =V (r) − P , induces efficient breach but excessive reliance (Rogerson, 1984; Shavell, 1980).To prove the former claim, note that the promisor (seller) will breach if−D > P − C, or,substituting forD, if C > V (r), which is the efficient condition givenr. To prove the latterclaim, note that the promisee (buyer) will chooser to maximize

F(V (r))[V (r) − P ] + [1 − F(V (r))]D − r,

which, after substituting forD, becomes

V (r) − P − r.

The first-order condition for the optimalr is given byV ′(r) = 1, which, compared to (2), showsthat the promisee choosesre > r∗. Intuitively, expectation damages fully insure promiseesagainst breach, so they ignore the possibility that breach may be efficient in high cost statesof the world.

Now suppose that the promisor has limited wealth,w ≥ 0, out of which he can pay damagesin the event of breach. In this case, the promisor will breach if

max[w − D, 0] > w + P − C. (3)

The wealth constraint is binding ifw < D,7 in which case the condition for breach becomes

C > P + w. (4)

Given (4), excessive breach will occur (givenr) if P + w < V (r), or equivalently, ifw <

V (r) − P , which must hold given the binding wealth constraint. Note that whenw = 0, (4)implies that the promisor will breach whenever he expects a loss from performance; that is,wheneverP − C < 0.

Given (4), the promisee will choose a level of reliance to maximize

F(P + w)[V (r) − P ] + [1 − F(P + w)]w − r, (5)


yielding the first-order condition

F(P + w)V ′(r) = 1. (6)

Comparing this to (2) shows that the promisee chooses too little reliance (r < r∗) because theprobability of performance is too low (though reliance is efficient conditional on the probabilityof performance).

Consider now the possibility of contract modification in the presence of a bankruptcy risk.For simplicity, we focus on the case where the promisor has zero wealth in the event of breach(i.e., w = 0). We first show that enforcement of modification results in efficient breach,assuming zero costs of renegotiation.

Let modification in this case take the form of a price increase in an amountm onceC isrealized. The feasible values ofm are determined by bargaining between the two parties, givenC, P, andr. The promisor’s options are to perform for a return ofP + m − C, or breach andpay damages ofw = 0. He can therefore be induced to perform for anym satisfying

m ≥ C − P. (7)

Thus, the price increase must at least cover the promisor’s loss.Similarly, the promisee can either agree to the modification and receive a net return of

V (r) − P − m − r, or allow the promisor to breach and receiveD − r = −r givenD = w =0. The resulting condition for performance is

m ≤ V (r) − P. (8)

That is, the price increase cannot exceed the promisee’s consumer surplus. Note that (8) impliesthat under full expectation damages, the promisee would not agree toany price increase (i.e.,(8) would becomem ≤ 0) because he would be fully compensated for his losses in the eventof breach. AsPosner (1998, pp. 110–111)notes, the promisor’s threat to breach, even in thepresence of a genuine economic change, is not credible if there is an adequate breach remedy.8

Conditions (7) and (8) provide lower and upper bounds, respectively form. If we assume thatmodified performance will occur whenever a positive range exists, then a sufficient conditionfor modification isV (r) − P ≥ C − P , or V (r) ≥ C, which is exactly the condition forefficient performance givenr. Thus, enforcement of modification potentially achieves efficientperformance when expectation damages fail to do so due to promisor bankruptcy.9

Figure 1illustrates this conclusion graphically. From a social perspective, performanceshould occur up to the point where the positively sloped cost line labeledC intersects thehorizontal line atV(r). This point is shown byC1 in the graph. However, in the absence ofmodification, bankruptcy causes performance to occur only up to the point whereC intersectsthe price line,P. This point is labeledC2. When enforceable, modification potentially allowsperformance to occur over the range betweenC2 andC1.

We next consider promisee reliance in the presence of modification. Since this choice ismade prior to the realization of the seller’s price, the promisee must anticipate the outcome ofmodification in those states where it occurs, including the specific amount of the price increase.Given the bounds above, we write this increase as follows:

m = C − P + α[V (r) − P − (C − P)] = C − P + α[V (r) − C], (9)


Figure 1. Range and division of gains from modification.

whereα is a parameter between 0 and 1, reflecting the allocation of the gains from renegotiation(Rogerson, 1984). Specifically, note thatm is equal to the lower bound in (7) plusα timesthe difference between the upper and lower bounds (the joint surplus). Thus, whenα = 1, mequals the upper bound, meaning the seller obtains all of the surplus, and whenα = 0, thereverse is true. In general,α will be between 0 and 1 (assuming for now that it is unrestrictedby the court), so that both the parties obtain some of the surplus.

Given the above, the promisee’s expected return from the contract, prior to the realizationof C, can be written

F(P )[V (r) − P ] +∫ V (r)

P

[V (r) − P − m] dF(C) − r, (10)

wherem is defined by (9). The first term captures the value of performance in those stateswhere modification is not expected to occur, and the second captures the value of performancewhere it does occur. Note that the buyer expects no compensation in the event of breach (whichoccurs with probability 1− F(V (r))) due to the seller’s zero wealth constraint.

The buyer’s optimal choice ofr maximizes (10). The resulting first-order condition is givenby

αF(P )V ′(r) + (1 − α)F (V (r))V ′(r) = 1. (11)

Let r̂(α) denote the solution to (11). Comparing (11) to (2) and (6) (withw = 0) shows thatfor α < 1, reliance is larger than the level the promisee would have invested if there were nopossibility of modification. Modification therefore generally increases the promisee’s relianceby increasing the probability that performance will occur, which makes the expected returnfrom reliance greater.

At the same time, however, reliance falls short of the first-best level, despite the fact thatperformance occurs up to the efficient point (i.e., up to the point whereC = V (r)), given thatthe promisee expects the promisor to extract a share of the surplus in the bargaining over the


amount of the price increase (i.e., givenα > 0). Further, as the promisor’s share becomeslarger, r̂(α) will fall further below r∗ (i.e., r̂(α) is decreasing inα). The intuition for thisresult can be seen by noting from (9) thatm is increasing inr for α > 0. Thus, by investingless reliance, the promisee can reduce the strength of the promisor’s bargaining position—and hence lower the amount of the price increase—by lowering the maximum amount he(the promisee) is willing to pay to induce performance. This reflects the inefficiency due to“opportunistic bargaining” over the price (a form of rent-seeking), even when such bargainingleads to efficient performance in the face of a genuine cost increase and an inadequate breachremedy.

Figure 1illustrates the distribution of the gains from modification. The net, or social, gainsfor anyC in the range of modification, sayC ′, is given by the difference between the upperbound in (8) and the lower bound in (7), orV (r) − C ′. In the graph, this distance is givenby the segmentxy. The lower bound is given by the amount of the cost overrun,C ′ − P , orsegmentyz, while the upper bound is the consumer surplus,V (r) − P , or segmentxz. Thecloserα is to zero, the closer the price increase is to the lower boundyz; and the closerα is toone, the closer the price increase is to the upper boundxz.

The preceding analysis implies that courts can improve the efficiency of the reliance decisionwithout interfering with efficient performance, merely by scrutinizing the amount of the priceincrease in the event of modification. Specifically, by limiting the amount of the price increaseto the minimum amount that will induce the promisor to perform, courts can eliminate the riskof rent-seeking by promisors and thereby create an incentive for promisees to invest in theefficient level of reliance. In the current model, this implies that the price increase should belimited toC −P , or the amount of the promisor’s cost overrun. The question is whether courtsactually undertake this sort of price scrutiny when judging modification cases, or whether theylimit their inquiry to enforceability—that is, only whether or not the price increase is a responseto a genuine increase in costs.Section 3attempts to answer this question by reviewing the lawof modification.

2.1. Seller’s cost of performance unobservable

Before confronting the case law, however, I comment briefly on the implications of relaxingthe assumption that the promisor’s cost of performance, once realized, is public information.I consider the case where the promisee cannot observe the promisor’s cost but the court can,for if the court cannot observe the cost, the analysis in this paper does not apply.10 Even inthis case, though, opportunistic modifications are possible if litigation costs prevent promiseesfrom seeking to overturn them.

Assume initially, however, that litigation is costless. In this case, only genuine modificationswill succeed because promisees will challenge all modifications, and the court will nullifythose judged to be opportunistic according to the Posner rule. In addition, the court can limitenforceable price increases to those that are cost-justified as proposed above. In short, theoutcome is identical to that in the certainty case.

The analysis is more complicated if litigation is costly. To illustrate, suppose that promisorsrealize either high costs (Ch) or low costs (Cl ), whereCh > P > C l . Thus, according to (4),high cost sellers (with zero wealth) will breach if they fail to obtain a price increase,11 while low


cost sellers will perform. In this setting, two types of equilibria are possible.12 The first arisesif the fraction of low cost sellers (potential opportunists) is small enough that promisees findit unprofitable to challengeany modifications, knowing that the majority (i.e., those proposedby high cost sellers) will be upheld. In this case, the court has no opportunity to scrutinizecontract modifications, and the analysis in this paper again does not apply.

The second type of equilibrium occurs if the fraction of low cost sellers is sufficiently large.The outcome in this case involves mixed strategies in which some low cost sellers seek priceincreases, and promisees sometimes challenge them in court.13 Under this equilibrium, thecourt can apply the augmented Posner test in those cases where the promisee challenges themodification.

3. The law of modification

This section focuses on the law of modification in situations where there has been a genuinechange in the contracting environment (specifically, a cost increase), thereby making modi-fication efficient according to the Posner rule. The focus, therefore, is not onenforcement ofthe price increase, which is assumed to be desirable, but instead on whether courts place anylimit on theamount of the increase. This issue, and its implications for efficient reliance, ap-parently have not been examined in the literature. I begin by re-examining the case ofGoebelv. Linn, which, due to Posner, has become the prototypical case for efficient enforcement ofmodification.

Recall that the case concerned a contract between a brewery and an ice company for deliveryof ice. The contract price was set at $1.75 per ton, or $2.00 if the supply was short. However,when the ice crop failed, the ice company claimed that it could not supply ice at those prices,so the brewery, which had a considerable amount of beer on hand, agreed to an increase inthe price to $3.50 per ton. The brewery later brought suit for reimbursement of its paymentsin excess of the $2.00 price, claiming that the price increase had been obtained under duress.

In examining this case, the court first inquired as to why the brewery had agreed to theprice increase rather than simply allowing the ice company to breach the contract and paythe resulting damages. As shown above, an expectation damage remedy should render thiscourse of action equivalent to performance from the promisee’s perspective, litigation costsaside. However, the court observed that this is not the case if the promisor is expected to bejudgment-proof in the event of breach, as may have been true here:

Suppose, for example, the defendants had satisfied themselves that the ice company under thevery extraordinary circumstances of the entire failure of the local crop of ice must be ruinedif their existing contracts were to be insisted upon and must be utterly unable to respond todamages; it is plain that then, whether they chose to rely upon their contract or not, it could havebeen of little or no value to them. Unexpected but extraordinary circumstance had rendered thecontract worthless; and they must either make a new arrangement, or, in insisting on holdingthe ice company to the existing contract, they would ruin the ice company and thereby at thesame time ruin themselves.14

Under such conditions, the court noted that it would be “very strange” if new arrangementscould not be made that would “provide for a price that would enable both parties to save their


interests.”15 That is, the modified contract should be enforced. It is important to emphasize,however, that enforcement should not turn on the promisor’s ability to obtain modified per-formance due to an inadequate breach remedy. After all, modification was also obtained inAlaska Packers’ Assn. v. Domenico16 for the same reason, but it was judged by the court to beunenforceable because it was purely opportunistic in nature (Posner, 1998, pp. 110–111).

Returning toGoebel v. Linn, the court, after having acknowledged that the price increasewas not evidence of duress (because it was not opportunistic), went on to consider the mag-nitude of the increase and concluded that it was fair: “But for the pre-existing contract theone now questioned would probably have been fair enough, and if made with any otherparty would not have been complained of.”17 Indeed, the reasonableness of the price in-crease in this case—from $2.00 to $3.50—becomes all the more evident when compared tothe amount that the brewery claimed it would have paid, given its reliance on the contract:“We had to pay most anything, if they asked $20; if we had no ice one day or two, if wehad been without ice, all our stock would have been spoiled.”18 This seems to suggest thatthe increase that the brewery actually paid, and which the court approved of, was proba-bly near the lower bound that would have induced it to perform rather than the maximumamount that the brewery would have been willing to pay. As the theory showed, limiting theprice increase to this amount is exactly what is necessary to create incentives for efficientreliance.

Other modification cases show that courts generally look favorably upon price increasesaimed at covering increases in cost sustained by the promisor as a result of unforeseen changes.For example, inBlakeslee et al. v. Board of Water Com’rs of City of Hartford,19 the court en-forced a price increase obtained by a contractor for building a dam when its costs increased dueto diversion of workers and materials at the outbreak of WW I. In doing so, the court recog-nized the contractor’s right to seek compensation to cover “the actual cost of the work, labor,and materials to be furnished.”20 Similarly, in Linz v. Schuck, the court allowed a contractorto collect “such additional sum as such unforeseen difficulties cost him” when excavation ofa cellar proved costlier than either party had anticipated.21 Finally, in Roth Steel Products v.Sharon Steel Corp., the court concluded that

In the final analysis, the single most important consideration in determining whether the de-cision to seek modification is justified is whether, because of changes in the market or otherunforeseeable conditions, performance of the contrast has come to involve a loss.22

In addition to the case law, the Restatement (Second) of Contracts, Section 89, states thata modification is enforceable “if the modification isfair and equitable in view of circum-stances not anticipated by the parties when the contract was made” [emphasis added]. Further,the fair and equitable standard requires “an objectively demonstrable reason for seeking amodification.”23 Likewise, the Uniform Commercial Code states that an enforceable modi-fication must be made ingood faith; that is, it must be “motivated by an honest desire tocompensate for commercial exigencies.”24

These standards suggest that enforceable modification is based on a two-pronged test:25 first,that the circumstances triggering the modification must have been unforeseen, and second,that the amount of the increase must be reasonable in the sense of reflecting the cost increaseincurred by the promisor. As we have seen, the first test focuses on creating incentives for


efficient performance in an uncertain contracting environment (the Posner rule), whereas thesecond test is concerned with creating incentives for efficient reliance by the promisee.

4. Conclusion

This paper has examined the problem of contract modification from an economic perspec-tive. The question of when it is efficient for courts to enforce modified performance in theabsence of consideration is well-trod ground. The accepted rule (by scholars and courts) isthat modifications that respond to genuine and unforeseen changes in the contracting environ-ment are enforceable, but those aimed merely at taking advantage of a party’s reliance on thecontract to extract a larger share of the gains from trade are not. Taking this rule as the start-ing point, this paper has examined the problem of creating efficient incentives for promiseereliance when faced with the threat of modification of the first type.

The problem is that promisees may underrely on the contract in order to reduce theirvulnerability to modification when they know that (1) modifications are enforceable accordingto the above rule, and (2) standard breach remedies are inadequate substitutes for performance,due, for example, to promisor bankruptcy. The analysis showed that incentives for efficientreliance can be restored if courts, when enforcing a price increase, limit the amount of theincrease to the promisor’s cost increase. Such a rule provides assurance to promisees thatpromisors will not be allowed to take advantage of promisees’ reliance on the contract toextract price increases that are not cost-justifiedex post. Our review of the law of modificationshowed that courts seem to be sensitive to the importance of proportionality between costincreases and allowable price increases.

Notes

1. Also seeLeff (1970), Johnston (1993), Muris (1981), andSchwartz (1992). Aivazianet al. (1984)andJolls (1997)argue that dynamic considerations may argue againstenforcing modifications, even if both parties find them beneficialex post.

2. 11 N.W. 284 (1882).3. 117 F. 99 (9th Cir. 1902).4. Previous analyses of renegotiation and reliance includeGraham and Peirce (1989),

Rogerson (1984), andSpier and Whinston (1995). None of these, however, considerspromisor bankruptcy as the reason for renegotiation.Rogerson (1984)in fact notesthat renegotiation does not occur under full expectation damages, whileGraham andPeirce (1989)andSpier and Whinston (1995)consider renegotiation under a stipulateddamage remedy.

5. In implementing this rule, I assume that courts are able to distinguish genuine costincreases from opportunistic increases made to appear genuine. Obviously, courts willmake mistakes, so the analysis here should be viewed as providing an idealized rule.At the conclusion ofSection 2below I note the implications of relaxing the assumptionthat courts can observe the promisor’s costs.


6. I abstract from risk-sharing aspects of contract modification. In general, it is difficult tospeculate on the impact of risk-aversion because it depends on the relative risk attitudesof the buyer and seller. See generallyPolinsky (1983).

7. For this constraint to be binding, the value of performance to the promisee (as em-bodied in the expectation damage remedy) must exceed the value of the promisor’sbusiness. This will be true primarily for new or small businesses, or those in financialdistress.

8. Also seeJohnston (1993). In addition to the bankruptcy threat, other reasons that dam-ages for breach might be inadequate in this sense include the presence of subjectivevalues of performance for promisees (Muris, 1981), reputational losses, and costs oflitigating for damages (Leff, 1970; Miceli, 1995).

9. See, e.g.,Dnes (1995), Leff (1970, pp. 36–38), andJohnston (1993). Leff discusses thecase where the promisee may be uncertain about the promisor’s wealth, which createsthe potential for solvent promisors to seek opportunistic modification by claiming to beinsolvent.Johnston (1993)formalizes this situation in a model without reliance. In thatcase, the ease with which information about the promisor’s solvency can be obtainedbecomes crucial.

10. SeeBaird, Gertner, and Picker (1994, pp. 109–118), who examine the case where thepromisee can observe the promisor’s costs, but the court cannot.

11. I assume that it is nevertheless efficient for high cost sellers to perform—that is,V (r∗) >

Ch.12. The analysis closely resembles that inKatz (1990).13. To see why mixed strategies are necessary, suppose that promisees challenge all mod-

ifications. Low cost promisors will therefore not seek price increases because theyknow they will be overturned in court. But then promisees will not find it profitableto challenge modifications, which will induce low cost promisors to seek price in-creases, and so on. Mixed strategies are necessary to prevent this sort of oscillation (seeKatz, 1990).

14. Goebel v. Linn, 11 N.W. 284, 285 (1882).15. Id., at 285–286. Also, seeAustin Instruments Inc., v. Loral Corp., 272 N.E.2d 533

(1971), andThe Selmer Co. v. Blakeslee-Midwest Co., 704 F. 2d 924 (1983), both ofwhich point to the inadequacy of the breach remedy as a reason for renegotiation.

16. 117 F. 99 (9th Cir. 1902).17. Id., at 286.18. Id., at 284.19. 139 A. 106 (1927).20. Id., at 112.21. 67 A 286 (1907).22. 705 F. 2d 134, 147 (1983).23. Restatement (Second) of Contracts (1981), § 89, Comment b.24. U.C.C., § 2-209:61, citingRoth Steel Products v. Sharon Steel Corp. 705 F. 2d 134

(1983).25. Johnston (1993)similarly notes the two-pronged nature of the test for enforceable

modification, but he interprets them solely in the context of efficient performance.


Acknowledgments

I acknowledge the comments of two referees.

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Documents

“Over a barrel”: contract modification, reliance, and bankruptcy