UNIVERSITY OF MICHIGAN

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1 UNIVERITY OF MICHIGAN JOHN M. OLIN CENTER FOR LAW & ECONOMIC CREDIBLE COERCION: ECONOMIC ANALYI OF THE DURE DOCTRINE IN CONTRACT LAW OREN BAR-GILL OMRI BEN-HAHAR PAPER # THI PAPER CAN BE DOWNLOADED WITHOUT CHARGE AT: MICHIGAN JOHN M. OLIN FOUNDATION WEBITE

2 1 CREDIBLE COERCION CREDIBLE COERCION: ECONOMIC ANALYI OF THE DURE DOCTRINE IN CONTRACT LAW Oren Bar-Gill and Omri Ben-hahar * Abstract This paper argues that enforcement of an agreement, reached under a threat to refrain from dealing, should be conditioned solely on the credibility of the threat. When a credible threat exists, enforcement of the agreement promotes both social welfare and the interests of the threatened party. If agreements backed by credible threats were not enforceable, the threatening party would not bother to demand a concession, and would simply refrain from dealing to the detriment of the threatened party. The doctrine of duress, which predominantly controls such agreements, only hurts the coerced party. By denying enforcement in cases where a credible threat exists, duress doctrine precludes the threatened party from making the commitment that is necessary to reach agreement. Paradoxically, it is in those circumstances where a threatened party has no alternative options or adequate remedies that, under duress doctrine, she cannot secure an agreement. The analysis in this paper suggests that, in dealing with agreements reached under threats to breach, courts should replace the duress methodology with a credibility inquiry. It discusses factors that would be relevant under such inquiry. Finally, it demonstrates some of the applications of this approach in the context of leading contract modification cases. pring 2003 Draft * Bar-Gill is a John M. Olin fellow in Law and Economics, Harvard Law chool and a Junior Fellow, the Harvard ociety of Fellows (bargill@law.harvard.edu); Ben-hahar is a Professor of Law and Economics, University of Michigan Law chool (omri@umich.edu). Helpful comments were provided by Yael Aridor Bar- Ilan, Lucian Bebchuk, Kevin Davis, Louis Kaplow, Eric Posner, teve havell, Robert itkoff, and workshop participants at Harvard, Michigan, and Northwestern Law chools. The authors acknowledge the financial support of the John M. Olin Centers for Law and Economics at Michigan and Harvard; Bar-Gill also acknowledges the financial support of the William F. Milton Fund of Harvard University.

3 2 CREDIBLE COERCION I. INTRODUCTION The negotiation of a transaction often involves threats by one party to refrain from dealing unless a particular provision, favorable to the threatening party, is accepted. For centuries, contract law has been searching for a unifying principle that will determine when such threats should be considered improper, rendering the resulting agreement unenforceable on the grounds of duress. Thus far, such a general criterion has failed to emerge. 1 One area in which duress jurisprudence has been particularly active involves the modification of previously agreed-upon contracts. When circumstances surrounding performance change relative to the parties contemplation, such that the original agreed-upon deal becomes less attractive for one of the parties, a demand for modification of terms, backed up by a threat to breach the original deal, is often made. ubsequently, the acquiescing party might challenge the validity of the modification, refusing to perform the renegotiated terms. The contract law doctrine of modification determines whether these renegotiated terms are enforceable. The common law traditionally viewed modifications as promises lacking consideration and thus wholly unenforceable. 2 This view eroded over the past century, a policy best illustrated by of the Uniform Commercial Code, according to which a modification of a contract is generally enforceable, unless as with any other agreement it was extorted by coercive means. 3 To determine when a particular threat to breach (or to refrain from transacting) is improper and coercive, one prominent branch of case law has focused on the perspective of the threatened party. Whenever this party is deemed to have had no reasonable 1 The history of generalization in this field offers no great encouragement for those who seek to summarize results in a single formula. ee Dawson, Economic Duress An Essay in Perspective, 45 Mich. L.Rev. 253, 289 (1947). 2 ee, e.g., Lingenfelder v. Wainwright Brewery, 15.W. 844, 848 (1891) ( a promise to pay a man for doing that which he is already under a contract to do is without consideration ). 3 7 CORBIN ON CONTRACT 28.6; FARNWORTH, CONTRACT 282 (3 rd Ed. 1999) ( In fashioning a solution to the problem of the enforceability of modifications, the drafters of the Code discarded the trappings of the doctrine of consideration to bare the real abuse of the bargaining process coercion. The result is remarkably consistent with the liberalized rules on duress. )

4 3 CREDIBLE COERCION alternatives but to surrender, her consent is viewed as coerced by the threat and the resulting deal is rendered unenforceable. 4 Thus, in the context of modification, if the threatened party acquiesces to a modification demand because her legal remedies for breach would be insufficient, or because no alternative partners can be found on short notice, her concession is unenforceable. Against this prominent line of cases, courts have occasionally followed a different principle, focusing on the perspective of the threatening party. Under this view, a demand that arises from an unanticipated change of circumstances, such as a cost increase, constitutes a legitimate reason for a modification, irrespective of whether the other party had reasonable alternatives. 5 What constitutes an improper threat and a coerced transaction has been the subject, not only of conflicting case decisions, but also of a significant body of scholarly work. Various criteria have been offered to evaluate whether a threat to breach (or to refrain from dealing) is coercive. Under one view, a proposal is a coercive threat if it reduces the possibilities open to its recipient; otherwise, if it expands the possibilities, it is a non-coercive offer. 6 Under another view, it matters if the resulting exchange is one-sided, namely, if it deviates from exchange values as established by the market. 7 Lastly, economic-oriented scholars have suggested that rent-seeking threats, which do nothing but shift value between the parties and increase transactions costs should be deemed improper. 8 This paper explores a different general principle for enforceability of deals reached under threats. If successful, this principle can contribute to the distinction between threats and 4 Restatement (econd) of Contracts 175 (1) ( If a party s manifestation of assent is induced by an improper threat by the other party that leaves the victim no reasonable alternative, the contract is voidable by the victim.) 5 ee, e.g., Angel v. Murray, 322 A.2d 630 (R.I. 1974) ( The modern trend appears to recognized the necessity that courts should enforce agreements modifying contracts when unexpected or unanticipated difficulties arise ). 6 CHARLE FRIED, CONTRACT A PROMIE (1981). 7 ee MICHAEL J. TREBILCOCK, THE LIMIT OF FREEDOM OF CONTRACT 81 (1993) (referring to the approach developed by Gordley and by Benson). 8 ee, e.g., Aivazian, Trebilcock, and Penny, The Law of Contract Modification: The Uncertain Quest for a Bench Mark of Enforceability, 22 Osgoode Hall L. J. 173 (1984); Frank Buckley, Three Theories of ubstantive Fairness, 19 Hofstra L. Rev. 33 (1990); Trebilcock, supra note 7.

5 4 CREDIBLE COERCION offers, and can provide a guideline for determining whether the acquiesced deal ought to be enforced or struck down on the grounds of duress. ince most of the duress cases concern modifications, rather than original negotiation of contracts, the analysis will focus on the threats to breach and the enforceability of the resulting modification agreement. To understand the proposed principle, consider first the interests of the threatened party. When the other party threatens breach unless a modification is conceded, a standard intuition suggests that it would be in the interest of the threatened party if the modification were not enforced. 9 After all, she is pressured to make a costly concession, and it would seemingly be in her interest if she can invalidate this incremental concession. Indeed, case law is replete with instances in which a threatened party who acquiesced to a modification demand challenges its validity in subsequent proceedings, reinforcing the intuition that a non-enforcement outcome is best for her. In contrast to this common understanding, the analysis in this paper argues that it could be in the interest of the threatened party if modifications to which she surrendered would be enforced. Although ex-post (after performance is rendered and the threat to breach is no longer pending) this party may seek to invalidate the conceded modification, ex ante (at the time when the threat is still pending) she might be better off committing to a modification. uch a commitment may be necessary, from the threatened party s point of view, to induce the other party to perform rather than breach the original promise. Performance, even under the modified terms, may be preferable over damages for breach. Whether the threatened party is indeed better off acquiescing to the threat depends on what would happen if she were to ignore the threat. This is where the focus shifts to the perspective of the threatening party. If unable to extract a modification, would the threatening party breach or perform the original contract? The threatening party is said to have a credible threat if it would be in his interest to breach the contract unless modified. If the threat was credible and breach would have resulted from its rejection, accompanied by insufficient remedies, it would indeed 9 WILLITON ON CONTRACT 7.36, at 573 (4 th ed., 1992) (justifying the preexisting duty doctrine in common law on the grounds that a modification provides no benefit to the promisor).

6 5 CREDIBLE COERCION be in the interest of the threatened party to acquiesce and prevent breach. If, instead, the threat to breach were not credible, such that breach would not have resulted from its rejection, the threatened party would be better off if the acquiesced modification were not enforced. Accordingly, the analysis in this paper demonstrates that a determination whether a proposal/threat renders the resulting deal unenforceable should depend solely on its credibility. Thus, for example, when a seller credibly threatens to withhold delivery unless a higher price is conceded, the buyer if she cannot secure reasonable alternatives or full damages would want to commit to a higher price. uch a commitment is her only way to avoid the consequence of breach. If, instead, the seller s threat is not credible, the buyer has nothing to lose from the non-enforceability of the modification. The analysis in this paper further suggests that the criterion developed under the duress jurisprudence, focusing on the availability of reasonable alternatives and on the adequacy of remedies, is misguided. It is misguided, if only because it is redundant: if the threatened party had adequate alternatives or fully compensatory remedies, she would not have surrendered to the threat. The fact that she did surrender indicates that she must have considered her other alternatives less desirable. Moreover, the no-reasonable-alternatives condition is misguided in a different, more troubling, sense. This condition is indifferent to the question of the credibility of the threat. It is thus ill equipped to promote the interests of threatened parties who have no adequate remedies and want to commit to modifications and avoid breach. It is also sub-optimal from a social perspective, leading to excessive incidence of inefficient breach. This theoretical analysis yields at least two doctrinal implications that have not been fully explored before. First, it suggests that the coercion test underlying much of the duress and modification jurisprudence is undesirable. econd, it suggests that any factor bearing on the credibility of the threat to breach should be taken into account in deciding whether to enforce the modification agreement The idea that enforcement of modifications can be in the interest of the threatened party has been recognized before. It has been argued that the ability to commit to a higher price in the presence of a credible threat to breach may be necessary to guarantee enforcement and to avoid the risk of default. ee, e.g., Richard Posner, Gratuitous Promises in Economics and Law, 6 J. Legal tud. 411,

7 6 CREDIBLE COERCION The remainder of the paper is organized as follows. ection II presents the basic analysis. ection III extends the basic model to allow for asymmetric information. ection IV explores circumstances that affect the credibility of the threat to breach. ection V considers some of the main doctrinal implication of the analysis. ection VI concludes. II. BAIC ANALYI A. etup Consider a seller (he) and a buyer (she) contracting over the sale of one indivisible asset. At period 0 the two parties sign the original contract, specifying the delivery of the asset by the seller to the buyer in exchange for a payment, p. 11 The value of the asset to the buyer is (1977); Alan chwartz, Relational Contracts and the Courts: An Analysis of Incomplete Agreements and Judicial trategies, 21 J. Legal tud. 271 (1992); Jason. Johnston, Default Rules/Mandatory Principles: A Game Theoretic Analysis of Good Faith and the Contract Modification Problem, 3. Cal. Interdisciplinary L. J. 335 (1993); FARNWORTH, CONTRACT (3d ed. 1999). In particular, Johnston s and chwartz s insightful papers make some of the arguments we develop in this paper within a similar analytical model, and throughout the analysis we give credit to these authors wherever their observations anticipated ours. Our analysis differs from that of Johnston and chwartz in several significant respects. First, we provide a different characterization to the bargaining process, which helps to separate analytically the credibility condition from the inadequacy of remedies condition. econd, while both authors argue that the enforceability of a modification should be conditioned upon a factor that resembles our credibility condition (Johnston, pp. 339, 340, 347, 366; chwartz, p. 309), our analysis proves that the credibility condition is the only relevant criterion. Third, we analyze formally the incentives under different legal regimes and in the presence of asymmetric information. Moreover, Johnston and chwartz focus on overall efficiency, and do not emphasize the advantage of enforceable modifications to the threatened party. Following the courts, we focus on the perspective of the threatened party. We also demonstrate that what is good for the threatened party also promotes efficiency. Finally, and perhaps most significantly, our analysis provides a different framework to evaluate the duress and modification doctrines. As a result, in critical respects we reach different conclusions than Johnston and others concerning the desirability of landmark court decisions. 11 This is clearly an incomplete contract. In particular, as will be clear below, the contract is economically incomplete in the sense that it is not contingency specific, that is, it does not specify the optimal provisions for every possible contingency. ee, e.g., Hermalin & Katz, Judicial Modification of Contracts Between ophisticated Parties: A More Complete View of Incomplete Contracts and

8 7 CREDIBLE COERCION v. The seller s cost of creating the asset (or parting with the asset) is thought to be c, at this period. Before period 1, an unanticipated change of circumstances might increase the cost of performance for the seller from c to C > c. It is assumed that performance is efficient, even with the higher price C, namely v > C. As a result of the cost increase, at period 1 the seller may demand to renegotiate the contract price. It is initially assumed that the cost increase is symmetrically observable by both parties. This assumption simplifies the basic analysis and helps flesh out the main results. It will be relaxed in section III below. If renegotiation is successful, the parties agree on a new price, P > p. Then, at period 2, the seller decides whether to deliver the asset to the buyer. Finally, at period 3, litigation may occur. There are two typical types of lawsuits. The first is a suit for the recovery of damages for breach of contract. If at period 1 the parties failed to agree on a modification, then the seller might decide to breach the contract at period 2. Consequently, at period 3 the buyer may sue for expectation damages, d. Ideally, expectation damages will be set to equal the buyer s loss, d = v p, but the analysis will also consider cases in which d deviates from this pure measure. ince no modification was agreed upon, this kind of lawsuit does not raise any issue regarding the validity of a modification. The second type of lawsuit arises if at period 1 the parties agree on a modification of the original contract and the contract price is raised to P. Once this modified price induces the seller to perform at period 2, the buyer may renege upon her period 1 concession. In this case, the seller will sue for the unpaid balance P p. It is here that the court has to decide whether to uphold the modification or invalidate it. The timing of the interaction between the seller and the buyer, as described above, is depicted in figure 1. Their Breach, 9 J.L. Econ. & Org. 230 (1993). In analyzing the legal treatment of contractual modification, it makes sense to assume such incompleteness. Only when the original contract is incomplete will the parties find beneficial opportunities to modify it. For similar accounts of contractual incompleteness and subsequent renegotiation, see e.g. Milton Harris and Bengt Holmstrom, On the Duration of Agreements, 28 Int l Econ. Rev (1987), and teven havell, The Design of Contracts and Remedies for Breach, 99 Quar. J. Econ (1984).

9 8 CREDIBLE COERCION Original contract signed Bargaining over modification eller performs / breaches the contract Litigation T Cost Realization The strategic interaction between the buyer and the seller is analyzed below. In examining the period 1 renegotiation and the seller s period 2 decision whether to perform or breach the contract, we will first analyze the period 2 incentives and later return to examine the period 1 bargaining. This backward induction approach is appropriate since the parties period 1 bargaining strategies depend on what they expect the seller to do at period 2. Thus, to analyze the period 1 renegotiation we must first understand the seller s decision patterns at period 2. ection II ends with a final step in the backward induction examining the ex ante effects on the period 0 contract design. B. The eller s Threat to Breach If the seller s cost rises from c to C but his attempt at modification of the price fails, will he perform or breach the initial contract? The seller s decision is based on a comparison between his performance payoff and his breach payoff. If the seller performs, he nets p C. If he breaches, a court will ideally order him to pay damages of d = v p at period 3. Generally, however, the burden imposed on the seller by these prospective damages is different than d, and may be either higher or lower. Denote this burden by D. 12 Comparing the seller s performance payoff and breach payoff, following a rejection by the buyer of the modification demand, the seller will decide to breach if and only if 12 The reasons why D differs from d has to do with imperfections in, and the cost of the enforcement process, resource constraints, and more. These factors will be analyzed in section IV infra.

10 9 CREDIBLE COERCION (1) C p > D When condition (1) is satisfied, namely, when the seller s net cost of performance exceeds the burden of remedies, we say that the seller has a credible threat to breach. 13 When the seller does not have a credible threat to breach, the buyer (who, recall, is assumed to have perfect information concerning the seller s cost) expects that the seller will perform the contract even if his modification demand is rejected. Accordingly, the buyer will reject any modification demand at period 1, regardless of whether a modification is enforced by the court. C. The Buyer s Decision: Modification v. Remedies for Breach We now turn to the case where condition (1) holds, namely, the seller has a credible threat to breach. Is it in the interest of the buyer to modify the contract? The buyer s bargaining strategy at the renegotiation stage is determined first and foremost by her outside option. The buyer may reject the modification demand, and after the seller breaches sue for damages. As discussed above, a court will ideally award the buyer damages of d = v p. Generally, however, the buyer s payoff in the event of breach may be different from d. Denote this payoff by D B. ince the buyer can attain at least D B without a modification, she will not agree to a modified price greater than PB = v DB. 14 Consequently, the highest price increase that the buyer will consider, i.e. the buyer s reservation price in the period 1 renegotiation, is: pb PB p = v p DB. Clearly, there will be no modification when p 0. Hence, a necessary condition for modification is B (2) D B < v p ( = d) When condition (2) is satisfied, we say that the buyer is inadequately protected by legal remedies and will potentially benefit from a 13 Note that condition (1) implies D < d. 14 If PB v DB, then v P B DB, and the buyer is better off waiting for the seller to breach and then collecting a damage award.

11 10 CREDIBLE COERCION modification of the original contract. Otherwise, she will reject a- priori any attempt by the seller to extract a modification, and obtain the legal remedy for breach. 15 D. Analysis of the Legal Regimes 1. The No-Enforcement Regime Consider first behavior under a legal regime where the court is expected to invalidate any modification. This is the old common law rule that deemed a modification to lack consideration, rendering it unenforceable. Under this regime, the buyer is entitled to recover the incremental price paid, P p. In such a scenario, if the seller performs at period 2, the buyer will indeed sue for restitution at period 3. Expecting this, the seller who has a credible threat to breach will not bother to seek a modification and will breach the contract. 2. The Unconditional Enforcement Regime Next, consider a legal regime where any modification is enforceable. The buyer will not agree to a modification unless the seller has a credible threat -- unless condition (1) holds. Further, the buyer will not agree to a modification unless condition (2) holds unless her remedies for breach are inadequate. Moreover, a modification will be agreed upon only if both parties can be made better off under it relative to their outside options. For the seller the new price must exceed the original price by at least p = C p D, the difference between the seller s performance payoff and breach payoff. This minimum price increase constitutes the seller s reservation value in the period 1 renegotiation. For the buyer we already saw that the maximum price increase would be pb = v p D B, her reservation value. The feasibility of a modification therefore depends on a comparison between the two reservation values. Clearly, a modification is feasible only if the maximum price increase that the buyer is willing to consider is greater 15 Other authors have invoked conditions in the spirit of condition (2). chwartz, supra note 10, discusses an access to the market condition, which is one important factor in assessing whether condition (2) is satisfied. Johnston, supra note 10, at pp , describes a condition that is identical to condition (2). In Johnston s model, however, conditions (1) and (2) are interlinked, as both are assumed to arise from changed circumstances, and thus their effects are not clearly distinguished. As we will show below, this distinction has critical normative implications.

12 11 CREDIBLE COERCION than the minimum price increase that the seller will accept. Namely, a modification is feasible only if (3) v C > D B D. We refer to (3) as the existence of a modification range condition. 16 The precise value of the modified price, between p + p and p + p B, depends on the parties relative bargaining power. Hence, under the unconditional enforcement regime, for a modification to occur three conditions must be met: (1) A credible threat: < C p ; D < ; and (3) Existence of a modification range: DB D < v C. We demonstrate below that the legal system can optimally focus on condition (1) alone. However, already at this stage we can simplify the analysis by noting that conditions (1) and (3) together imply (2) Inadequacy of remedies: D B v p ( = d) condition (2). 17 When the seller has a credible threat to breach and a modification range exists, necessarily the buyer is inadequately protected by legal remedies. Before turning to the normative analysis, we can summarize the descriptive observations as follows: Claim 1: When a modification is legally enforceable, it will occur if and only if conditions (1) and (3) hold, namely if and only if the seller has a credible threat to breach and a modification range exists. When a modification is legally unenforceable, it will not occur. Note that, in the case of perfect information, a modification would not occur unless the seller has a credible threat. It might be conjectured that even without a credible threat, since the buyer has much to lose from breach, a two-sided bargaining game would ensue whereby the buyer would concede some modification of price. However, if the buyer knows the threat not to be credible, it would be 16 When D B = D, a modification range exists whenever performance is efficient, namely, whenever v > C. 17 Condition (3) can be rewritten as D < D + v C. ubstituting condition (1), we obtain D B < C p + v C = v p. B

13 12 CREDIBLE COERCION irrational from her perspective to concede a modification. The buyer would be risking nothing by rejecting the threat and leaving the seller the choice to perform, rather than breach, the initial contract. E. The Regimes Compared Proposition 1: Under perfect information, the threatened party is better off, and social welfare is increased, if, whenever a modification is agreed upon, the court enforces it. Remarks: (i) Intuition. Whenever the seller has a credible threat, it is in the buyer s interest to have the resulting modification enforced. urely, the buyer prefers to pay the original, lower price, rather than the modified one. However, because of the credibility of the threat, this outcome is not feasible: it is not incentive-compatible for the seller. Recognizing that her most preferred outcome cannot be attained, the buyer s remaining choice is between the modified contract and damages for breach. Put differently, enforcement of a modification is advantageous to the buyer because it helps her commit a higher payoff to the seller. If the modification were not enforceable, the buyer would not be able to make such a commitment the seller would expect the buyer to invalidate the modification and the seller would choose to breach, inflicting on the buyer her least preferred outcome. (ii) ocial Welfare. The transaction between the buyer and the seller is efficient, even when the cost of performance is C (since v > C ). Therefore, from a social welfare perspective, the contract should always be performed. Consequently, any breach by the seller reduces social welfare. Thus, although the modification has a distributive effect a rent extracted by the seller it also has a total welfare effect. Absent the modification, the seller would have inefficiently breached the contract. Therefore, enforcement of modifications not only promotes the private interests of the threatened party, but also increases social welfare. 18 (iii) Inadequacy of Remedies and the Doctrine of Duress. Proposition 1 argues that under perfect information all modifications 18 Note that non-enforcement of modifications creates an inefficiency even in the complete information case. Compare to Johnston, supra note 10, ection II.A, where the inefficiency result is linked to asymmetric information.

14 13 CREDIBLE COERCION should be enforced. In particular, it implies that enforcement should not depend on the adequacy of the buyer s remedies. The point is that if the buyer acquiesced to the modification demand, it must be the case that she perceived the remedies to be inadequate, or else she would have rejected the demand and settled for remedies. The existence of the modification indicates that the buyer prefers an enforceable modified agreement to breach remedies. If a court were to use the inadequacy of remedies as grounds not to enforce the modification, it would undermine the buyer s preference and force her to settle for the inadequate remedies. As we will show in greater detail in ection V below, this is precisely what many courts do when applying the doctrine of duress in modification cases. Whenever remedies are inadequate, (that is, whenever condition (2) is satisfied), the modification is deemed to be extortive, rendering it unenforceable. ince, according to our analysis, modifications will be agreed upon only if condition (2) is satisfied, the Duress regime renders all agreed upon modifications unenforceable. From an economic perspective, it is equivalent to the polar regime of non-enforcement. Proposition 1 can be interpreted to suggest that this conditional enforcement regime is inferior to unconditional enforcement of modifications. (iv) The Doctrine of Changed Circumstances. Another approach, which is less common but nevertheless occasionally applied in courts, conditions enforcement of a modification on the existence of a demonstrable change of circumstances affecting the seller s cost of performance. 19 One way to interpret this doctrine is to say that modifications are enforceable only if condition (1) holds, i.e. if the changed circumstances created a credible threat to breach. ince, according to claim 1 of our analysis, condition (1) is necessary for modifications to emerge, this regime is equivalent to the polar regime of unconditional enforcement. Thus, proposition 1 can be interpreted to suggest that the doctrine of changed circumstances can lead to the optimal result. However, with symmetric information, courts do not need to actually verify changed circumstances, and can reach the optimal outcome by enforcing modifications unconditionally. 19 ee, e.g., Angel v. Murray 322 A. 2d 630 (1974).

15 14 CREDIBLE COERCION III. AYMMETRIC INFORMATION The analysis thus far suggests that courts should enforce any modification that the parties agree upon. Opportunistic, non-credible threats of breach will be rejected by the buyer, implying that agreed upon modifications must be arising from credible threats, which, in turn, arise only if the seller s cost increased. This analysis, however, assumes that the buyer can distinguish between credible and noncredible threats. For if she cannot so distinguish, she will not be able to selectively acquiesce to demands when they are credible, and reject them otherwise. ince the credibility factor often depends on the seller s costs, which the buyer cannot observe, the symmetric information model in ection II has only limited application. Accordingly, we extend the analysis in this section to the case of asymmetric information. A. etup At period 1, when the seller realizes an updated cost, the buyer can only observe the distribution from which this cost is drawn. For simplicity, assume that there is a probability p that the seller s cost will be C > c, and a probability (1 p) that the seller s cost will remain c. The buyer knows p. If the cost remains c, then condition (1) does not hold (i.e. c p < D ), and the seller prefers performance of the original contract over breach and the resulting damage payment. If the cost of performance turns out to be C, then condition (1) holds (i.e. C p > D ) and the seller prefers breach. Apart from the seller s preference between performance and breach, a second question concerns the existence of a modification range. When v C > D B D, a modification range exists for either low or high cost realizations (we assume that v c > D B D ). When C is so high that v C < D B D, a modification range exists only for the low cost realization. We assume that the buyer has all the bargaining power at the modification stage. This assumption simplifies the technical analysis and does not diminish the generality of the results. True, in many modification settings, in which sellers apply extortionary bargaining methods, this assumption is not realistic. Nevertheless, different assumptions about the division of bargaining power will only affect

16 15 CREDIBLE COERCION the terms of the modification, and not the incidence of modification or its social value. 20 The basic analysis above examined only two legal regimes: No- Enforcement versus Unconditional Enforcement of modifications. Because the perfectly informed buyer was able to reject all noncredible demands, the only role remaining for courts was to enforce the conceded modification, and our analysis supported an unconditional enforcement regime. The intermediate regimes, under which modifications are conditionally enforceable, and where courts have to verify the existence of some condition, were demonstrated to be equivalent to the polar regimes. In the present setting, however, the imperfectly informed buyer cannot reject all non-credible demands. Accordingly, courts can have the additional role of distinguishing between modifications that are a result of credible threats and those that are not. Thus, the analysis examines in greater detail the two intermediate regimes. Under one intermediate regime, the Duress regime, a modification is enforceable only if the buyer was not coerced, namely, only if condition (2) does not hold. Under the other intermediate regime, the Changed Circumstances regime, a modification is enforceable only if the seller s threat to breach was credible, namely, only if condition (1) holds. B. Analysis of the Legal Regimes 1. The No-Enforcement Regime If a modification is never enforceable, the introduction of asymmetric information has no effect on the analysis. The seller will never bother to make a modification demand. When the cost of performance turns out to be unexpectedly high (i.e. the period 1 cost realization is C), the seller will simply breach the contract. 2. The Duress Regime As in the basic model, a selective enforcement regime based on condition (2) is equivalent to the No-Enforcement regime. Asymmetric information about the seller s cost does not affect the basic observation that modifications will be agreed upon only if condition (2) is satisfied. Namely, the buyer will only agree to a modification if her remedies for breach are inadequate, but this is precisely the condition that renders the agreement voidable. 20 ee Appendix C.

17 16 CREDIBLE COERCION Accordingly, this legal regime makes all agreed upon modifications unenforceable. Under this regime, too, the seller will breach whenever his costs rise to C. 3. The Unconditional Enforcement Regime We next study the polar regime under which modifications are always enforced. Here asymmetric information plays a critical role. When the seller makes a threat to breach, the buyer cannot distinguish between the case in which the threat is credible (when the seller s cost increased to C) and the case in which it is not credible (the cost remained c). The seller will take advantage of this uncertainty. In choosing her bargaining strategy, the buyer has to choose between a pooling offer and a separating offer. ince the seller s cost is either C or c, we have to consider each type separately. If the seller s cost is C, he will accept a price increase of at least p = C p. If the seller s cost is c, he will perform even D without any price increase, namely p = 0. In choosing her strategy, the buyer will either offer no price increase (inducing separation between high cost and low cost sellers, namely only a low cost seller will acquiesce; a high cost seller will breach), or she will offer a price increase that would surely be accepted by the seller, regardless of his type, i.e. p = C p D (a pooling outcome). With the former D B alternative the buyer nets π + ( 1 π) ( v p). With the latter she nets v p ( C p D ). Comparing the two payoffs, the buyer will offer a price increase if and only if or: v C + D (4) > [ D + ( 1 π ) ( v p) ] π, B C p D v p D π >. 21 B 21 A comparison between conditions (3) and (4), reveals that condition (3) is more easily satisfied, when conditions (1) and (2) hold. pecifically, condition (4) implies condition (3), but not vice versa. That is, under asymmetric information modification is less likely to occur. To see why, recall that condition (3) requires p that the buyer s reservation price B, will be greater than the seller s reservation price, p. This imp lies v p DB > C p D. Put differently, condition (3) requires that the buyer s payoff from paying the high cost seller s reservation

18 17 CREDIBLE COERCION That is, facing a risk that the seller might breach the contract and leave the buyer inadequately protected by remedies, the buyer has to decide whether to insure against this outcome by paying a price increase to every type of seller. When this risk the likelihood p of increased cost of performance is sufficiently high, the buyer will offer such a price increase. 22 Hence: Claim 2: In the unconditional enforcement regime, a modification will be agreed upon if and only if conditions (2) and (4) hold. Relative to the full information case, the renegotiation outcome changes in two ways. First, a modification of the price might occur with a c-type seller, namely, even when the seller s threat to breach is not credible. econd, a modification may not occur even when conditions (1) and (3) hold when the seller does have a credible threat since condition (4) is less likely to hold than condition (3). 4. The Changed Circumstances regime Consider the version of the Changed Circumstances regime under which a modification is enforceable if and only if condition (1) holds. A court is expected to verify whether the seller had a credible modification demand and only in such a case enforce the modification. We assume that at period 3 the court can perfectly verify the seller s performance cost. 23 The outcome under this regime is identical to the outcome under the unconditional enforcement regime in the full information case. Here, too, the seller would not make a threat to breach unless it is credible. The buyer simply accepts any modification demand at period 1, and later if it turns out that the seller s cost did not rise to price will be greater than her payoff from refusing modification and getting v p C p D > D damages: ( ) B. In comparison, condition (4) requires that the buyer s same payoff from paying the high-cost seller s reservation price will be greater than her payoff from refusing modification and getting either damages or performance at the original price: v p ( C p D ) > π DB + ( 1 π ) ( v p). ince v p > DB (when condition (2) holds), then condition (3) is more easily satisfied than condition (4). 22 As in the perfect information case, the buyer will not concede to any modification (i.e. will not offer any price increase), unless she is inadequately protected by the legal remedies, i.e. unless condition (2) holds. 23 The imperfect verification case is analyzed in appendix B.

19 18 CREDIBLE COERCION C, namely if the buyer expects that the court will invalidate the modification she sues for restitution. Given the buyer s strategy and the court s selective enforcement approach, the seller will make a modification demand whenever condition (1) holds, namely if and only if the high cost C is realized. tated differently, when courts can perfectly verify the credibility of the seller s modification demand, the buyer s imperfect information is immaterial from an economic point of view. Under a selective enforcement regime, the buyer can effectively postpone her decision whether to modify the contract until period 3, at which time the court will make the accurate observation and validate the modification only when the threat were credible, namely, only when it is in the buyer s interest that a modification, rather than breach, occur. 24 Indeed, as in the full information model, in the asymmetric information case with selective enforcement all modifications that are made are enforced. True, courts are required, as a prerequisite for enforcement, to verify that the seller had a credible modification demand. That is, there are potential modifications that would not pass this scrutiny and would not be enforced. However, in equilibrium such modifications that do not satisfy condition (1) are never made. In addition, as in the symmetric information case, there will be no modification unless a modification range exists (i.e. unless condition (3) holds). Hence: Claim 3: Under the Changed Circumstances regime, a modification will occur if and only if conditions (1) and (3) hold, namely if and only if the seller has a credible threat to breach and a modification range exists. 24 A formal analysis of the imperfect verification case shows that this result - that modifications occur only when the cost rises to C holds in a model where courts verification is imperfect. ee Appendix B. In the appendix, we construct a model, where the court might fail to recognize a cost increase. In this model, the risk of judicial error reduces the seller s expected payoff from a modification, with the sole effect of increasing his reservation price at the modification stage. At the same time, the risk of judicial error induces an equal magnitude increase in the buyer s payoff, thus increasing her reservation price. As a result, the conditions for a modification remain as in the perfect verification case, and judicial error only affects the terms of the modification.

20 19 CREDIBLE COERCION E. The Regimes Compared Proposition 2: Under asymmetric information, the Changed Circumstances regime, under which a modification is enforced only if the threat to breach is credible, is the superior regime in terms of maximizing both the buyer s welfare and overall social welfare. Remarks: 25 (i) Why No-Enforcement is Bad. In the polar regime in which modifications are not enforceable, the seller will breach whenever his cost of performance turns out to be unexpectedly high, C. Therefore, in this regime the seller will breach with probability p. These breaches cause a welfare loss, since by assumption the transaction is efficient even if the cost of performance is high (i.e. v > C ). Moreover, the buyer would be better off had she been able to prevent these breaches by committing to an enforceable modification. Note that the disadvantage of this polar regime has nothing to do with the introduction of asymmetric information. The inability to commit to an enforceable modification reduces the buyer s welfare for the same reason that an inability to make an enforceable promise reduces a transactor s ability to enter into welfare increasing transactions. (ii) Why the Duress Regime is Bad. As explained above, the Duress regime, under which a modification is enforceable only if coerced only if the buyer s resort to remedies is inadequate -- is effectively equivalent to the no-enforcement regime. Accordingly, any time the seller s threat to breach is credible, breach will occur, causing a social welfare loss and a private loss to buyer. (iii) Why Unconditional Enforcement is Bad. In the other polar regime in which modifications are unconditionally enforceable, the buyer s welfare is compromised in the following way. Due to her lack of information the buyer might agree to a modification even when the actual cost of performance is c, such that the seller does not have a credible threat to breach. In addition, she might turn down a modification demand when the actual cost of performance is C, and suffer the consequences of breach. Note, however, that the likelihood of an inefficient breach is smaller, relative to the no-enforcement regime. Here, for an inefficient breach to occur it is not enough that 25 The following remarks describe the intuition underlying proposition 2. The formal proof of the proposition 2 is provided in Appendix A

21 20 CREDIBLE COERCION the seller has a credible threat, but also the buyer must find it in her interest not to propose a price increase (iv) The Optimality of the Changed Circumstances Regime. If changed circumstances are understood to arise if (and only if) they render the threat to breach credible, this regime is optimal for the buyer. Here, as in the symmetric information case, modifications are made if and only if conditions (1) and (3) are satisfied. Thus, the likelihood of an inefficient breach is the smallest: it will only occur when the seller s cost is high and condition (3) is not satisfied, namely, when there is no modification range. ince condition (3) is more easily satisfied than condition (4), inefficient breach is least likely to occur under this regime. F. Ex Ante Effects Thus far, the analysis has focused on periods 1 and 2, that is, on how the legal regime would shape incentives at the modification and performance stages. We now turn to examine the effects of the different regimes on incentives at earlier stages. In particular, the analysis explores how the two prevailing regimes, the Duress regime and the Changed Circumstances regime, affect ex ante investments, risk sharing and the design of the initial contract. 1. Relationship-pecific Investments A major purpose of contracts is to induce relationship-specific investments (i.e. reliance investments) by the contracting parties. 26 Absent an enforceable commitment, it is commonly recognized that the hold-up problem may lead to underinvestment: If one party makes a relationship specific investment, after the investment is sunk the other party will be able to extract some of its returns by renegotiating more favorable terms. 27 This hold-up might dilute incentives to engage in ex ante investments, and thus reduces the value of the transaction ee, e.g., teven havell, Contracts, in Peter Newman (ed.), The New Palgrave Dictionary of Economics and the Law, Vol. 1, pp (1998). 27 ee Oliver Hart, Firms, Contracts, and Financial tructure, ch. 2 (1995). 28 uch dilution will occur if the remedies for breach are under-compensatory and are not increasing in the level of investment. An opposite effect might occur when remedies are under-compensatory but increasing in either the level of investment or

22 21 CREDIBLE COERCION It might be conjectured that the Changed Circumstances regime, which makes modifications enforceable in a relatively greater set of cases, would reduce relationship-specific investment. If an investing party anticipates that her counterpart might be able to make a credible threat to breach and thus modify the contract and extract some of the returns on her investment, her incentives to invest would diminish. Accordingly, so goes the argument, the Duress regime, which is strategically equivalent to a No-Enforcement regime and which reduces the incidence of modifications, would shield the contractual investment from subsequent hold-up, leading to greater investment and greater overall surplus. This conjecture stems from an intuitive premise that the buyer s investment is better protected under the Duress regime. Generally, this premise is not valid. In fact, more of the buyer s investment can be forfeited under the Duress regime. True, under the Changed Circumstances regime some of the investment s returns can be extracted by the other party, to an extent that depends on the legal remedy for breach and on the relative bargaining power of the parties. 29 But similarly, under the Duress regime the investing party does not enjoy the full return to the investment since an undercompensated breach may occur. How often she loses her investment depends on the likelihood of breach, which in turn depends on how her investment affects the remedy she stands to collect. 30 Accordingly, the buyer will invest more under the Changed Circumstances regime whenever the marginal effect of investment on her post hold-up payoff exceeds the marginal effect of investment the value of performance. Here, excessive reliance investment may result. ee havell, supra note 26; William P. Rogerson, Efficient Reliance and Damage Measures for Breach of Contract, 15 Rand J. Econ. 39 (1984). 29 Under the Changed Circumstances regime, whenever the seller has a credible threat to breach and a modification is agreed upon the buyer s payoff is v( r) p p( r), where r denotes the buyer s investment. The value that is extracted from the buyer, p(r), may depend on r. If p(r) is increasing (decreasing) in r, underinvestment (overinvestment) will follow. If, instead, p is independent of r, optimal investment will be taken. Thus, if the price increase depends solely on the seller s cost, the buyer s investment would be optimal. 30 Under the Duress regime, whenever the high cost contingency is realized and the seller breaches the contract the buyer s payoff is D B. ince D B is a function of v(r), an increase in the investment might increase the buyer s remedy.