September 16, 2005
Conglomerate Junior Scholars Workshop: Gamage & Kedem on the Consideration Paradox
Posted by Christine Hurt

Welcome back to the final installment of Conglomerate Junior Scholars Workshop!  Our last (but not least) featured paper is Resolving the Paradox of the Consideration Doctrine by David Gamage and Allon Kedem.  Both authors are recent law school graduates.  Allon is currently in a federal clerkship, and David is a visiting assistant professor at the University of Texas School of Law in the Emerging Scholars program.

Our expert reviewer for this paper is Larry Garvin, of the Moritz College of Law at Ohio State University.  Prof. Garvin writes in the areas of contract, sales, and behavioral law and economics.  He also has a fortchoming textbook from Aspen with Gordon on entrepreneurial finance.  Prof. Garvin's comments appear above and below the fold:

In Resolving the Paradox of the Consideration Doctrine, David Gamage and Allon Kedem set themselves one of the persistent problems in the common law of contract: why the law of consideration insists on bargain, on the one hand, but does not police the adequacy of consideration, on the other. How, then, can we justify consideration doctrine in light of our assumption that contract law seeks to give effect to the intentions of the promisor at the time of promise? Surely parties intending to be bound should then be bound, whether the promise is based on bargain or gift.

Gamage and Kedem start by showing the weaknesses in the traditional explanations and the significant incoherence of current doctrine. They then suggest that we should abandon our premise that effecting the intent of the parties to be bound is a laudable object. Rather, they propose that we ask whether the parties wanted the option to be legally bound at all. They base this less-than-intuitive shift on option theory, particularly the work of Aghion and Hermalin. In a world of welfare maximizers with asymmetric information about the likelihood of breach, and contracts consisting only of two terms – the size of the promise and the level of sanctions for breaching – we will see a “signaling spiral.” Parties with above-average reliability will offer proof of their reliability. This lowers the perceived (and actual) value of promises from the remaining promisors. Those above the new average will likewise seek to signal their relative reliability, and so forth. Of course, those with below-average reliability will try to mimic their more reliable colleagues. As the authors demonstrate formally, we would see either a pooled equilibrium at an inefficient level of sanctions or a separating equilibrium, with unreliable promisors offering excessively large promises and reliable ones offering excessively large sanctions for breach. Manipulating the damages measure and the other constants in the model can affect whether allowing the parties to be bound enhances welfare or not, from which the authors conclude that the models “can only disprove the dominant wisdom that parties who take advantage of a legally binding option necessarily desire the existence of that option.” But the data allowing the efficient result to be calculated do not, and probably cannot, exist.

How, then, to separate binding from non-binding promises? Gamage and Kedem propose that loosening the assumption that contracts contain only two terms may let us do so. Suppose contracts also may define the scope of a promise and its level of return payments. Then we may see a way out. Some types of promises resist commodification, making bargains over these terms “socially awkward.” Looking at a wide range of scholarship in anthropology, sociology, philosophy, and economics, they conclude that social norms barring this sort of unseemly behavior are strongest in many gift relations, particularly those centered in trust-building and status-enhancing. In contrast, exchange relations allow for this sort of bargaining. So, less intuitively, do altruistic promises, though resort to interdependent utility comparisons yields the same result. Where social norms inhibit the use of consideration, the authors propose a default rule of unenforceability. They recognize, though, that they have no way to determine whether the parties to these promises would prefer the option of enforceability, so they also propose some tie-breaking factors – whether the welfare of society would rise were the law involved, whether the obligations were explicitly promises, whether the welfare gains of enforcement to the parties are clear

As this lengthy summary suggests, Gamage and Kedem make an intricate and layered argument. Their article seems to me especially innovative in its use of option theory to study consideration (though other topics in contract have benefitted from its use, as recent articles by Avery Katz in Virginia and Bob Scott and George Triantis in Columbia illustrate). And one does not expect an article filled with game theory to bring the insights of anthropology and sociology to bear on its central issues. This eclecticism is, I think, a strength of the article, and adds richness and context to its analysis. All that said, there are a few spots where the analysis seems less than complete or less than persuasive. The incompleteness may have been a strategy, to avoid adding bulk to an already substantial paper, but I think in places it leaves important questions underanswered. (This was especially noticeable as the article proceeded, which may suggest that the later sections are more nearly works in progress than the former.) As I read through the game theory, for example, I waited in vain for the references to Akerlof’s work on lemons markets, which seems to me quite closely related to the authors’ analysis. (Ditto some of the work of Michael Spence.) I could also add important writers on altruism and the nature of promising – Jon Elster and Diego Gambetta come to mind, but there are many others – whose work might add texture to that section of the paper. The discussion of trust-building promises might make a bow in the direction of transaction-cost economics. One might also take a closer look at some of the classics of the consideration literature, such as Edwin Patterson’s defense of consideration. And the authors state that they believe they are the first scholars to observe that “social norms sometimes prevent parties from voicing even nominal consideration.” Surely not?

More substantially, I’m not sure all of the arguments cohere. The long discussion of game theory ends by suggesting that because the authors’ model can find the option to be bound either welfare-enhancing or welfare-diminishing, that we cannot assume that the parties to an agreement would wish the option to be bound. But, as they point out, this depends entirely on the values they set for their constants. Are their values realistic, either for promises overall or for defined classes of promises? It may be that for a realistic range of values (particularly those for damages and for the costs associated with enforcement), the option to be bound is either clearly welfare-enhancing or clearly welfare-diminishing. (I note as well that they model the costs of fulfilling a promise by squaring the size of the promise, a not-trivial step which does not seem empirically supported.) This leads to a query about one of the assumptions of the Aghion-Hermalin model that Gamage and Kedem adapt here. Aghion and Hermalin point out that their model assumes that the parties have access to only one signal, and they show that restricting access to that signal may improve efficiency. But if the parties have access to many signals, restricting access to only a subset may actually reduce efficiency. Gamage and Kedem do much with the literature on extra-legal aspects to promise enforcement here, and with great effect, but I was left a little uncertain whether their game-theoretic analysis fully takes this into account. The parties to an actual agreement will draw conclusions about the likelihood of performance from more than the signals set out in the course of negotiation, and changing consideration doctrine will affect only some of them.

The authors’ use of the commodification literature also could be stronger. It might, for example, take into account the conflicting threads of contractarian and non-contractarian analyses of marriage and related promises (for a handy reference, see Bob Hillman’s excellent treatment in The Richness of Contract Law). And I wonder whether the authors should put quite as much emphasis on the signaling rationale for charitable promises as they do. Certainly some donations give status, in a relatively benign version of Veblenesque conspicuous consumption. Naming opportunities on professorships, buildings, colleges, or whole universities come to mind. But many donations, especially more modest ones, seem more clearly explained by altruism, particularly if made without the expectation of public acknowledgment. In addition, some rather broad statements in the conclusion may need a bit of qualification. I’m not sure that their tie-breaker rule about welfare-enhancement yields a line drawn just where they want it. Any small promise will, if enforceable and enforced, bring about enforcement costs well in excess of the value of the claim, whether the promise is basically donative or bargain-based. And their statement that “[t]he default rule should always be against involving the law in private disputes” may not capture their point here. If they distinguish private disputes from those involving social welfare-enhancement, then the line drawn cuts jaggedly across traditional bargain and traditional gift alike. (I should note that Gamage and Kedem point out that many of the problems of traditional analysis arise because the law tries to determine which promises are socially valuable. But don’t they take this into account as one of their tie-breakers?)

Finally, the authors give two examples of promises that their theory leaves unenforceable, but that might properly be enforced should empirical work show that the harm from potential enforcement is low or the costs of barring proof of reliability high. Their examples are charitable subscriptions and merchant firm offers. I suppose I can accept this for charitable subscriptions, but merchant firm offers? As Learned Hand pointed out in Baird v. Gimbel, there is always the possibility of making an option contract that will have the effect of a firm offer. But is this remotely practicable? Put otherwise, what is to be gained by requiring the empty recitals of an option contract when merchants already have means of making offers that are not firm? Perhaps another example would be more apt. Most of these comments are peripheral, and most of the others probably reflect more a need for more complete exposition than a need for rethinking. The core of the article – a broadly-based, fresh, and nuanced analysis of a thorny problem – is important and worthwhile, and I think it will make a real contribution to the already distinguished literature on consideration.

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