Punishment and Disgorgement as Contract Remedies

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Punishment and Disgorgement as Contract Remedies

1. Introduction

For corrective justice the remedy corrects the injustice suffered by the plaintiff at the defendant’s hands. This chapter examines the implications of this simple statement for contract damages. The focus will be on two kinds of damage award for breach of contract: punitive damages and damages that require the disgorgement of gains. The fact that over the last decades these two kinds of damage award have received notable elaboration by the highest courts in Canada, England, and Israel¹ attests to the continuing relevance of the issues that they raise.

In private law the idea that compensation is an appropriate remedy is generally accepted. The award of compensation reflects the plaintiff’s entitlement to recover at least the loss that the defendant’s wrongful act has caused. More problematic is the issue of whether compensation is also the limit of what the plaintiff can be awarded. Damages that go beyond compensation and aim at punishment or disgorgement operate in circumscribed situations and are subject to special, often controversial, justifications.

Contract law, however, poses a special difficulty. Here the very notion of compensation is uncertain and its primacy disputed. The standard measure of damages for breach of contract is the expectation measure, which puts the plaintiff in the position in which the plaintiff would have been had the contract not been breached. In their classic article on contract damages Fuller and Perdue denied that this measure, which reflected the value of something that the promisee did not yet have, was compensatory.² Expectation damages, they suggested, might better be viewed as having the quasi-criminal purpose of penalizing the promisor for breaching the contract.³ This suggestion raises the possibility that a punitive impulse is present even in the most routine award of contract damages. On this view, truly compensatory assessments of contract damages are comparatively rare, whereas noncompensatory damages merely extend and make more explicit the non-compensatory policies already pervasive in contract damages.

At the heart of these issues about remedies lies the more fundamental issue: what is the nature of the right to contractual performance? So far as corrective justice is concerned, the remedy is merely the continuation at the remedial stage of the correlativity of right and duty that defines the parties’ relationship. Accordingly, the first step to specifying the plaintiff’s remedy against the defendant is to identify the right that contract law gives the plaintiff and the correlative duty that it lays upon the defendant. I turn to this in section 2, presenting a contrast between the function that Fuller and Perdue assign to the contract remedy and Kant’s now largely forgotten treatment of contractual right. The Kantian account also casts light, as I contend in section 3, on the inaptness of requiring the disgorgement of gains resulting from contract breach, despite the superficial attractiveness of preventing wrongdoers from profiting from their wrongs. In section 4, I turn to punitive damages, addressing first the preliminary question of how corrective justice and punishment—and the institutions devoted to them—coexist and are differentiated in a legal order based on rights. Finally in section 5, I discuss the difficulties that emerge from the elaborate but ultimately unsatisfying recent attempt in Canada to work out a coherent treatment of punitive damages for contract breach.

2. Contractual right

What, then, is the nature of a contractual right and how does an award of damages undo the violation of that right?⁴ The basic rule of contract damages is that damages are awarded on the expectation measure: the plaintiff is to be put in the position that the plaintiff would have been in had the contract not been breached. Is there the internal connection that corrective justice requires between the injury to the promisee’s contractual right and what the award of expectation damages restores? In other words, are expectation damages consistent with corrective justice?

This question was the starting point of the celebrated article on contract damages by Fuller and Perdue, who answered it in the negative.⁵ In their view the purpose of corrective justice is “the maintenance of an equilibrium of goods among members of society.”⁶ This the law accomplishes by awarding compensatory damages “to heal a disturbed status quo.”⁷ In the contracts context, corrective justice can be seen to be at work in the protection accorded to the restitution and reliance interests; the equilibrium of goods represented by the status quo has been disturbed in the former both by a gain for the defendant and an identical loss for the plaintiff, and in the latter by a loss for the plaintiff. Expectation damages, they argue, are different. Such damages protect a future expectancy—“something [the plaintiff] never had”—rather than a loss already suffered. “[T]his seems on the face of things a queer kind of ‘compensation.’”⁸ And so they contend that “[i]n passing from compensation for change of position to compensation for loss of expectancy we pass… from the realm of corrective to that of distributive justice.”⁹

Having discarded corrective justice, Fuller and Perdue then locate the rationale for expectation damages in considerations of policy. They suggest that expectation damages are an effective means of protecting the reliance interest. Expectation damages function not only as compensation for reliance losses (for reliance can consist in loss of the opportunity to enter other contracts) but also as a quasi-penal prophylaxis against breaches of contract that occasion reliance losses. Moreover, expectation damages promote and facilitate business agreements, which in turn stimulate economic activity, especially within a credit economy. In this way expectation damages attest, in their view, to the intertwining of legal institutions and the economic system.

The basic presupposition of this account is that corrective justice does not operate in the absence of a disturbance of the status quo’s equilibrium of goods among members of society. Unless there is a loss (as occurs with detrimental reliance) or a gain that corresponds to a loss (as when the restitution interest is in play), an award of damages cannot be construed as the working of corrective justice. Expectation damages, Fuller and Perdue argue, are not truly compensatory: by breaching the promise, the defendant merely withdraws a future good without inflicting a present loss. Only when the plaintiff relies on the prospect of receiving this good and thereby puts the future to some present detrimental use does the plaintiff suffer a loss that grounds a claim for compensation.¹⁰ Of course, by awarding expectation damages the law signals its willingness to treat the promise as creating something of present value. But one cannot deduce the justification of expectation damages as compensating for the loss of a present value from their mere existence. Apart from policies like the protection of reliance and the promotion of commerce (so Fuller and Perdue claim), there is no argument, independent of a circular appeal to the consequences that the law attaches to a breach, for regarding the promise as creating a present right in the expectancy.¹¹ In and of itself, they assume, a contractual undertaking does not suffice to do so.

Crucial to this reasoning is the idea that contract itself does not transfer the subject matter of the contract to the promisee. If contract did so, expectation damages would lose their mystery: given that the subject matter of the contract would belong to the promisee, its value would of course determine the level of compensation owed when the promisor withholds it through breach. Since Roman times, however, the law has distinguished between contract and conveyance.¹² At common law, only specific kinds of contracts, such as contracts of sale, effect an immediate transfer of title. Thus an agreement to sell (as contrasted with a contract of sale) gives the purchaser not a property interest in the object to be sold, but only the expectation of owning such an object in the future. Yet if the vendor breaches, the purchaser is nonetheless, under the rule of expectation damages, entitled to the object’s value. This seems strange. Usually one’s entitlement to the value of something stems from one’s ownership of the thing that has that value. The rule of expectation damages thus presents the paradox that the law, by requiring that the promisor make good the value withheld through the breach of the contract, treats the promisee as entitled to the object’s present value even though it does not yet regard the promisee as owner of the object itself.

To resolve this paradox, it is worth considering Immanuel Kant’s account of the distinction between in rem and in personam rights. This account provides a response to the kind of position subsequently put forward by Fuller and Perdue.¹³ In Kant’s understanding, law is a system of universal reciprocal freedom that includes the freedom to acquire rights to what is external to the interacting parties as self-determining agents. Such external rights mark a relationship between the right-holder and the object of the right that imposes a correlative duty on others. The different kinds of external rights reflect the categories of the understanding that deal with relations. Accordingly, the distinction between rights in rem and rights in personam expresses juridically the epistemological distinction between the relational categories of substance and causality respectively.¹⁴ An in rem right relates the holder of the right to substance—that is, to something that all others are obligated to leave intact; an in personam right relates the holder of the right to a causality—that is, to an act that a promisor is obligated to perform because of the relationship with the promisee. A relation to substance is necessary for an in rem right to be good against the whole world; a relation to causality is necessary for an in personam right to be good against a particular person.

Kant is explicit about the nature of a contractual right. It is not a right to the subject matter of the contract. Nor is it a right to the situation that would result from the performance of the promised act. Rather, it is a right merely to the performance of that act, to what Kant calls “another’s choice to perform a specific deed.”¹⁵ Kant formulates this important conclusion as follows:

By a contract I acquire something external. But what is it that I acquire? Since it only the causality of another’s choice with respect to the performance he has promised me, what I acquire directly by a contract is not an external thing but rather his deed, by which that thing is brought under my control so that I make it mine.—By a contract I therefore acquire another’s promise (not what he promised), and yet something is added to my external belongings; I have become enriched (locupletior) by acquiring an active obligation on the freedom and means of the other.¹⁶

Thus, Kant continues, what the promisee acquires through a contract is not a right to a thing but a right against the specific person obligated to perform the requisite act.¹⁷

This Kantian account of contractual entitlement provides a basis in corrective justice for the expectation measure of damages. By breaching the contract, the defendant unjustly deprives the plaintiff of the performance to which the plaintiff is entitled. The law undoes that injustice by restoring to the plaintiff either the specific performance that has been lost or the value of that performance. This value, in turn, reflects the value of the subject matter of the contract. Hence the plaintiff is entitled to damages that put the plaintiff into the position that the plaintiff would have been in had the contract not been breached. This is so not because the plaintiff has acquired an entitlement to (in Kant’s formulation) “what was promised,” that is, the thing that was the subject matter of the contract, but rather because the plaintiff has acquired the promise itself, that is, the act that the defendant is obligated to perform. The value of the thing promised is merely a way of measuring the value of the promise itself. The plaintiff has not acquired the thing promised “directly” (as Kant notes),¹⁸ but the thing figures indirectly in the plaintiff’s entitlement because the entitlement’s value reflects the value of the thing.

This account resolves the Fuller–Perdue perplexity, that expectation damages seem to be “a queer kind of compensation” in that they give the plaintiff something that the plaintiff never had.¹⁹ It is true that the plaintiff never had the thing promised; its loss is therefore not something for which the plaintiff can rightly claim compensation. But the plaintiff did have an entitlement to the performance itself; it is for the infringement of this entitlement that expectation damages compensate. Kant thereby answers the question that implicitly troubles Fuller and Perdue, “How can the law treat the plaintiff as entitled to the thing’s value if the plaintiff is not entitled to the thing?” The plaintiff turns out to be entitled to the thing’s value because that value determines the value of the performance to which the plaintiff is entitled. Both the Kantian account and the Fuller–Perdue critique of expectation damages presuppose the disjunction between contractual performance and ownership of the subject matter of the contract. But this very feature of contract that is problematic for Fuller and Perdue is what for Kant characterizes contract as a distinct kind of right.

The two accounts employ different conceptions of what is involved in providing a justification for the rule about expectation damages. For Fuller and Perdue justification consists in identifying the social purposes that the rule serves. Indeed, they regard this conception of justification as so well established that it has achieved a pervasive triteness.²⁰ Therefore, once they dismiss the suggestion that expectation damages maintain the equilibrium of goods among members of society, they are free to rummage through the repertoire of social purposes until they alight on the protection of reliance and the promotion of commerce. Kant, in contrast, working in the tradition of corrective justice, does not justify legal concepts by reference to a social purpose, because that would involve the law’s treating the parties as means rather than as agents who interact as ends in themselves. Instead, Kant views justification as immanent in a system of rights. Because a system of rights requires that the action of one self-determining person be consistent with the freedom of another, a rule is justified simply inasmuch as it manifests this consistency. Conversely, a restriction of self-determining activity for any reason except consistency with the freedom of others (for example, a refusal to give legal recognition to contractual entitlement) would eo ipso be unjustified. Thus, once a rule can be understood as the juridical manifestation of self-determining agency in one person’s interaction with another, no further work remains for justification to do. The rule is justified by virtue of its expressing the self-determining freedom of the interacting parties. This freedom forms the baseline from which deviations count as injustices. And then the undoing of such injustices in accordance with corrective justice partakes of the normativeness immanent in the system of rights and duties as a whole.

A virtue of the Kantian account of contractual entitlement is that it is consonant with the compensatory function that law itself implicitly assigns to expectation damages. In awarding the plaintiff the value of what the contract would have given, the law treats promisees as entitled to the expectancy that breach deprives them of. In contrast, a long and complicated narrative—which Fuller and Perdue attempted to provide—is needed to divert expectation damages from their ostensibly compensatory role to the remedial policies identified by Fuller and Perdue. Although the classification of interests that Fuller and Perdue offered has taken hold, their account of expectation damages and the reconceptualization of contract law that this account entails have, on the whole, had little effect on the law.²¹ The interest in securing the promised performance or its equivalent remains “the only pure contractual interest.”²² This interest in performance as the distinctive feature of contractual entitlement is the focus of Kant’s attention. In providing a theoretical account that allows us to understand expectation damages for what they purport to be—that is, as compensation to the plaintiff for an injustice suffered at the defendant’s hands—Kant’s treatment of contract exemplifies the commitment of corrective justice to understand the basic structure of private law in the law’s own terms.

3. The disgorgement of gains from breach

Whereas expectation damages, whatever their proper theoretical basis, are well established in the law, awards based on the plaintiff’s gains are more controversial. The question of whether the promisee is entitled to what the promisor has gained from the breach has been called “devilishly difficult.”²³ Favoring gain-based awards are strong ethical intuitions that promises should be kept and that those who breach their contracts should not profit from their wrongs. On the other hand, the difficulty in working out the applications of a new gain-based principle reinforces the suspicion that the traditional approach may be justified after all.

In many contract situations gain-based awards lie at the margins of the law’s traditional compensatory framework. One such situation occurs when the defendant’s gains may be used as a means of measuring the plaintiff’s losses. For example, when the defendant competes with a plaintiff to whom the defendant has given an exclusive license to sell or manufacture a certain commodity, the usual approach is to treat the defendant’s gain as evidence of the profit that the plaintiff lost through the breach.²⁴ Another such situation occurs when defective performance saves the promisor an expenditure without ultimately causing the promisee a further loss. Then the promisee can deduct what the promisor saved from the agreed price in order to bring the payment into line with what the promisee received, thus preventing what turns out to be an overpayment.²⁵ Yet another such situation occurs when the promisor builds in breach of a negative covenant with the promisee but without causing the promisee financial loss. The promisee’s entitlement to receive, in lieu of an injunction, the amount that reasonably would have had to be paid for securing a relaxation of the covenant can be interpreted either as gain-based or as compensatory.²⁶ A fourth such situation occurs when the breach of contract is also the breach of a fiduciary duty, when the aggrieved fiduciary can secure an accounting of the principal’s profits, which would have been unavailable from a mere breach of contract.²⁷ A fifth such situation occurs when a purchaser breaches a provision of the contract of sale that limits the price at which the item can be resold.²⁸ Disgorgement to the original seller of the purchaser’s excess profit on resale can perhaps be justified on the ground that, so far as the purchaser is concerned, the seller retained the value of the item above the price limit.

It is tempting to regard such miscellaneous instances of gain-based recovery not as particular applications of traditional categories, but as the scattered embers of a general conception of gain-based damages, to be collected into a new and explicit principle of disgorgement for breach of contract. An appealing analogy from the law of torts beckons. For centuries the owner of an object that the defendant converted and sold has been able, by “waiving the tort,” to recover the proceeds of the sale from the defendant, even when this would give the owner more than the value of the lost object.²⁹ The gain-based award that is controversial for breach of contract is universally accepted for the misappropriation of property. This difference, one might suppose, is entirely a product of history rather than reason. For why should profiting from another’s contractual right be treated less severely than profiting from another’s proprietary right?

In recent years two important cases, one from Israel and the other from England, have provided the most extensive discussions favoring the disgorgement of gains from contract breach. In Adras Building Material v. Harlow & Jones³⁰ the defendant had agreed to sell steel to the plaintiff, but when the price of steel spiked, the defendant instead sold the steel stored for that purpose to a third party. Because the plaintiff did not purchase substitute steel at a higher price before the market receded to its former level, no loss was proved. The Supreme Court of Israel awarded the plaintiff the gain that the defendant realized by selling its steel to the third party above the contract price. In Attorney-General v. Blake³¹ a former employee of the intelligence service, who had been convicted of spying and had escaped from prison, breached his contract of employment with the Crown by publishing his memoirs. Although he was not a fiduciary and the published information was no longer confidential, the House of Lords held that the Crown was entitled to the money owed to him by the publisher, on the ground that in the circumstances the Crown had a legitimate interest in preventing him from profiting from his breach of contract.

The basis of disgorgement in such cases is the sentiment that one should not profit from one’s wrongdoing. This sentiment has obvious moral resonance. It treats the breach of contract as a wrong—that is, as an act that the promisor was morally obliged not to commit. By striking the gains of contract-breach from the hand of the promisor, disgorgement gives teeth to the long-standing principle that promises are to be observed (pacta sunt servanda).

In this respect disgorgement is at odds with the notion of efficient breach. Efficient breach, a dominant idea in the economic approach to contract theory, postulates that a contract breach from which the promisor gains more than the value of the promisee’s expectancy is economically efficient.³² By allowing the promisor to gain more than would be sufficient to redress the promisee’s loss, the breach moves the subject matter of the contract to its most valued use. In this way, the self-interested preferences of the parties tend to the production of the greatest social good. From the economic point of view, therefore, no reason exists for the law to discourage such a breach. Conversely, requiring the promisor to disgorge gains made through the breach discourages the promisor from engaging in this wealth-maximizing step.

On the other hand, disgorgement involves the following difficulty from the standpoint of corrective justice. The fact that the promisor has profited from committing a wrong appears to supply an intuitively plausible reason for requiring the promisor to surrender the gain, but not for transferring that gain to the promisee. The taint that attaches to the promisor’s gain by the wrongful manner of its acquisition does not in itself make the promisee rather than someone else the justified recipient of that gain. To be sure, the gain was realized through a breach of contract with the promisee, but the question that corrective justice raises is whether this breach establishes not merely the historical origin of the gain—its cause in fact, to use tort terminology—but also the normative connection between the gain and the promisee’s entitlement to it.³³