higher bid prices, and ultimately, a greater cost to the public which ultimately bears the cost of road construction ..... Brentwood D.C.69. To the extent ..... decision of Lord Denning in Morris v Ford Motor Co Ltd. [1973] 1 Q.B. 792. 61. Iacobucci J.
Third-party Beneficiaries in the Supreme Court: Categorization and the Interpretation of Ambiguous Contracts Norman Siebrasse*
I.
INTRODUCTION In London Drugs Ltd v Kuehne & Nagel Int'l Ltd.1 the Supreme Court of Canada announced
significant changes to the law of third-party beneficiary contracts, with the majority holding that the third parties could claim protection of a contractual limitation of liability if the parties to the contract so intended. The case gave rise to three separate lengthy opinions, replete with extensive discussion of existing doctrine, thorough policy analysis and sober consideration of the role of the Court in effecting legal change. When the issue arose again a year later, in Edgeworth Construction Ltd. v N.D.Lea & Associates2, the brief majority decision appeared to simply apply now settled law to the facts at hand. But on second reading the decision is unconvincing: it avoids a major legal issue which is raised squarely and was left open by London Drugs; its application of the law of negligent misrepresentation is dubious; and it strains the limits of acceptability in contractual interpretation.
Because the doctrinal analysis in Edgeworth is so unpersuasive, closer scrutiny reveals the underlying motivations of the Court. The Court's analysis becomes much more convincing and coherent when explained as an attempt to determine the optimal contract terms in the light of an unclear or ambiguous contract. Economic analysis suggests that this is the correct approach to contractual interpretation. But while the Court's underlying approach is sound, the application may be criticized. In determining the optimal contract both the Court's view as to the optimal contract and express terms of the
contract at hand are relevant. Edgeworth in particular indicates that the Court is overly confident of its own view of the optimal terms, and insufficiently attentive to the contract itself.
It is also apparent that the majority has effectively adopted La Forest J.'s dissenting view in London Drugs, that ordinary employees are presumed to have no duty of care in tort to their employer's customer and it will take clear contractual language or unusual circumstances to displace this presumption. This is entirely consistent with the previous point, as La Forest J.'s argument establishes that in general we would expect the optimal contract not to impose liability on ordinary employees. Unfortunately, the majority has adopted La Forest J.'s presumption only implicitly and its formal analysis consists of a case-by-case application of general tort principles.
This may be an attempt to avoid the perils of categorization;
unfortunately it has led the Court into the perils of ad hoc analysis.
This article first argues that the majority's doctrinal analysis in both cases cannot plausibly explain the results. The analysis is then recast as a search for optimal contract terms, and the effect of the Court's perception of the optimal contract terms on its interpretation of the contract is discussed. Finally the insistence by the Court on applying broad principles on a case-by-case basis and its concomitant reluctance to adopt La Forest J.'s more categorical approach is addressed.
II.
FACTS AND HOLDINGS Both London Drugs and Edgeworth concern tort claims between two parties who are at either
end of a contractual chain, but not within privity. In London Drugs, the earlier case, the plaintiff London -2-
Drugs Ltd. had stored a transformer with the Kuehne & Nagel Int'l Ltd. pursuant to a contract which limited the liability of the "warehouseman" to $40.3 When the transformer was damaged by the negligence of Kuehne & Nagel's employees the plaintiff pursued a claim against the individual employees to the Supreme Court. (Its recovery against Kuehne & Nagel was limited to $40 at trial, and this was not disputed on appeal.)
Iacobucci J. speaking for the majority in London Drugs,4 had no difficulty in holding that the employees owed a duty of care to the plaintiff.5 The main issue, in his view, was whether the requirement of privity could be relaxed to allow the employees to take advantage of the limitation of liability in the contract between their employer and the plaintiff as third party beneficiaries. He concluded that such a change in the law was justifiable, but in order for the employees take advantage of the clause "the limitation of liability must, either expressly or impliedly, extend its benefit to the employees (or employee) seeking to rely on it."6 Iacobucci J. emphasized that it is the "intention [of the parties] as stipulated in the contract" which will determine whether this requirement is met.7 In all the circumstances of the case, the majority concluded that "the parties must be taken as having intended that the benefit of the clause would extend to....the employees," and the term "warehouseman" in the contract must be interpreted as meaning "warehousemen."8 The liability of the employees was accordingly limited to $40.
In a concurring opinion McLachlin J. agreed that the employees owed a prima facie duty of care to their employer's customer.9 She also agreed with Iacobucci J. that privity should no longer be a bar to reliance on the contract by third parties such as the employees.10 -3-
However, she disagreed on the
interpretation of the contract in the case at hand: she was of the view that "the only reasonable interpretation is that the term 'warehouseman' refers to the employer and does not include the employees."11
This led her to a consideration of the tort doctrine of voluntary assumption of risk. She stated that "the question of whether there are circumstances qualifying or negating the duty of care 'can only be answered in the context of the factual matrix including especially the contractual structure against which such duty is said to arise'". 12 She noted further that "Waiver and exemption clauses, whether contractual or not, have long been accepted as having [the effect of negating or limiting the duty of care in tort]". 13 In light of this analysis she concluded that the contract and the limitation clause it contained were part of the "concatenation of circumstances"14 giving rise to the tort duty, so that the duty owed by the defendants to the plaintiff was thereby limited.
It should be noted that there is no doctrinal inconsistency between McLachlin J.'s position and the majority position in London Drugs. In McLachlin J.'s view voluntary assumption of risk can apply to limit liability even if the parties to the contract in question did not intend to establish the defendants as third party beneficiaries.15 The first stage of the inquiry is therefore whether the parties intended the contract to protect specified third parties. If the answer is yes, the parties can take advantage of the clause; if no, then, in McLachlin J.'s view, we must proceed to ask whether the plaintiff's nonetheless assumed the risk. While Iacobucci J. called her tort analysis "complex and somewhat uncertain"16 it was neither specifically disapproved nor discussed in any detail. The majority simply did not have to proceed with the tort analysis -4-
because of its conclusion that the limitation of liability provision was intended to benefit the employees.
For both McLachlin J. and Iacobucci J. the major issue concerned the articulation of very general principles of contract and tort law. For both, in applying these principles to the facts the limitation of liability clause was central. La Forest J. specifically rejected this view, saying "the real issue is no different from what it would be if no clause appeared in the contract. Ultimately what we are concerned with is whether it is appropriate to impose a duty on employees to compensate their employers or those who contract with them for the employees' negligence in carrying out an activity the contracting parties have set in motion."17 La Forest J. narrowed the focus from general tort or contract law to the law in relation to employees. His consideration of the policy relating to employees led him to the conclusion that only specific and reasonable reliance by the plaintiff on the employees would justify liability.18 While La Forest J. noted that "reliance on an ordinary employee will rarely if ever be reasonable"19 he did not establish a rule that employees will never be held liable. An express or even an implied undertaking of responsibility by the employee would establish reasonable reliance. In other words, in the case of ordinary employees La Forest J. would reverse the usual broad presumption that the negligent party will be held liable, but just as parties can contract out of liability, so employees can contract into potential liability. Further, while "ordinary" employees would presumptively not be liable in tort, special types of employees, such as a ship's master or a professional employee might be held liable.20
The facts in Edgeworth were very similar to those in London Drugs except that in place of individuals attempting to claim protection of a limitation of liability as third party beneficiaries, we have both -5-
a firm and individuals. The appellant Edgeworth Construction Ltd., a construction company operating in British Columbia, tendered successfully on a project to build a section of highway in the Revelstoke area. The respondent N.D. Lea & Associates had designed the project and prepared the plans and specifications under contract to the Ministry of Highways. The Ministry in turn incorporated these plans and specifications into its contract with Edgeworth, along with a clause disclaiming responsibility for errors in the plans. There was no direct contractual link between Edgeworth and N.D.Lea. Edgeworth lost money on the project allegedly because of errors in the specifications and construction drawings. Edgeworth did not proceed against the Ministry, primarily because it wanted to continue to do business with the Ministry21, although the disclaimer clause would have made any such an action difficult to sustain in any event.22 Rather, it brought suit against N.D.Lea directly and against the individual engineers who had affixed their seals to the plans.23
The decision in the Supreme Court was brief and reads as an application of well-established law to the facts of the particular case. McLachlin J. for the majority24 had no difficulty in deciding that the defendant firm did indeed owe a duty of care in tort to the plaintiffs on the basis of the test for negligent misrepresentation set out in Hedley Byrne25. Then, following London Drugs, she turned to consider whether the contract between the plaintiff and the province negated that duty of care and concluded that the clause in question "does not purport to protect the engineers against liability for their representations."26 The defendant firm was accordingly held liable. However, the individual engineers escaped liability, as "the only basis on which they are sued is the fact that each of them affixed his seal to the design documents,"27 and this was held insufficient to establish any duty of care. -6-
La Forest J. wrote a short concurrence, noting that because the individuals in this case were professional engineers, the argument in favour of imposing liability was stronger than in London Drugs, but not strong enough so that reliance was reasonable. Nonetheless, while the plaintiff was reasonably relying on the skills of the defendant firm, they could not possibly have been relying on the individual engineers for indemnification in case of negligence. He thus affirmed his view set out in London Drugs that liability will generally not be imposed on individual employees.
III.
FLAWS IN THE DOCTRINE In the result, the individual engineers were absolved in both cases, while the firm was held liable.
This suggests that La Forest J.'s explicit view that the nature of the defendant is more important than the wording of the contract in determining whether liability. A closer examination of the cases confirms this suspicion.
While in London Drugs Iacobucci J. asserted that respect for the intent of the contracting parties motivated his decision, in applying the doctrine to the facts he concluded that: When all the circumstances of this case are taken into account, including the nature of the relationship between the employees and the employer, the identity of interest with respect to contractual obligations, the fact that the appellant knew that employees would be involved in performing the contractual obligations, and the absence of a clear indication to the contrary, the meaning of the term "warehouseman" in s.11(b) of the contract must be interpreted as meaning warehousemen.28
He did not claim that we can infer from the circumstance that the parties in fact intended the employees to benefit from the clause: he claimed no more than that the interpretation given "does not offend the words -7-
chosen by the parties."29 As McLachlin J. forthrightly recognized,30 it was a policy decision by the Court to imply a term benefitting the employees. Hence Iacobucci J.'s remark that "In the case at bar, the parties have not chosen language which inevitably leads to the conclusion that the respondents were not to benefit from [the limitation of liability] of the contract of storage,"31 which makes it clear that the Court is implicitly applying a presumption that employees are to benefit from a limitation of liability clause.
This comes very close to La Forest J.'s position that the employees owe no duty at all unless the contract expressly so provides. The very significant difference is that Iacobucci J.'s approach does not embody a well-articulated general presumption, but purports to be no more than a conclusion drawn from the specific facts of the case. This means that the employees will be prima facie liable if there is no limitation of liability clause at all in the contract between the employer and the customer; and more insidiously, the approach leaves ample room for another court, on consideration of "all the circumstances" to come to the opposite conclusion.
McLachlin J.'s analysis in London Drugs was overtly less concerned with the fact that the defendants were ordinary employees, as the wording of the clause itself provided ample support for her view that the plaintiff had assumed all risks, regardless of who created them.32 In this her analysis appears to turn more strongly on the wording of the limitation of liability, and so is perhaps even more susceptible to a different result on different facts.
Of course it is not necessarily undesirable that different facts and a different clause should give rise -8-
to a different result, but it does leave room for conclusory reasoning. This is manifest in Edgeworth. In that case McLachlin J. found that the corporate defendant did owe a duty of care to the plaintiff, just as did the defendant employees in London Drugs. And as in London Drugs she found that the limitation of liability clause did not apply to the defendant; but in Edgeworth she was speaking for the majority on this point. Therefore, following her analysis in London Drugs, the next question should have been whether, given the concatenation of circumstances, including the contractual limitation of liability and despite the prima facie liability of the defendants, liability was limited because the plaintiffs had agreed to voluntarily assume the risk.33 This issue was not pursued, an omission which is astonishing in light of the full text of the exclusionary clause (which was not cited in full in the Supreme Court decision): This Contract is made and entered into by the Contractor and the Minister on the distinct understanding that the Contractor has, before execution, investigated and satisfied himself of everything and of every condition affecting the works to be executed and the labour and material to be provided, and that the execution of this contract by the Contractor is founded and based upon his own examination, knowledge, information and judgment, and not upon any statement, representation, or information made or given by, or upon any information derived from any quantities, dimensions, tests, specifications, plans, maps or profiles, made, given or furnished by the Minister or any of his officers, employees or agents, and that any such statement, representation, or information, if so made, given or furnished, was made, given or furnished merely for the general information of bidders and is not in anywise warranted or guaranteed by or on behalf of the Minister; and that no extra allowance will be made to the Contractor by the Minister for any loss or damage sustained in consequence of or by reason of any such statement, representation or information being incorrect or inaccurate, or on account of unforeseen difficulties of any kind.34 While the second part of the clause may be read as simply limiting the liability of the Ministry, it is difficult to imagine a clearer statement of voluntary assumption of risk than is contained in the first part of the clause. This clause squarely raises the issue which the majority felt did not need to be addressed in London Drugs, namely whether McLachlin J.'s "complex and uncertain" analysis is indeed the law. But there was no
-9-
discussion whatsoever of voluntary assumption of risk, much less any indication that McLachlin J.'s earlier analysis was doctrinally incorrect.
It may be that in Edgeworth McLachlin J. has simply conceded that she was outvoted in London Drugs and is now applying the majority approach in that case to the facts in Edgeworth. If so, Edgeworth demonstrates the malleability of a case-by-case determination of the intent of the parties, unfettered by any clear presumptions as to that intent. Her analysis of the clause itself is largely confined to the remarks that it "does not purport to protect the engineers against liability for their representations," and that it "is entirely consistent with the conclusion that the protection was intended for the benefit of the province alone."35 Surely the clause is equally consistent with the opposite conclusion. It is certainly not so different from that in London Drugs as to compel a different result. Such conclusory remarks would be justifiable against the background of a general presumption that a limitation of liability clause does not benefit third-parties, in which case any clause which did not explicitly protect the third parties would be deemed to apply only to the party in privity. However, McLachlin J. makes it clear that no such general presumption is being used, and that it is "the facts of the case"36 which do not give rise to the inference that the third-parties were intended to be protected. Presumably, then, the circumstances and context in Edgeworth were not such as to lead to the conclusion that the clause extended to the purported beneficiaries. Of course, the most obvious "circumstance" is that in Edgeworth the defendant which was found liable is a corporation.
This cursory treatment of the clause suggest that voluntary assumption of risk was not discussed because it would have led almost inevitably to the conclusion that corporate defendants were not liable and - 10 -
the majority believed for other reasons that they should be liable. This indicates that in London Drugs itself voluntary assumption of risk was advanced not as a general principle, but as an ad hoc device to counter the broad tort presumption that the negligent party will be liable in the case of the individual employees.
This impression is strengthened by the treatment of the individual employees in Edgeworth. Both relaxation of privity and voluntary assumption of risk would operate to exculpate both the individual engineers and the firm, or neither. In order to find that the individual engineers were not liable McLachlin J. was therefore forced to conclude that they did not owe a duty of care: The position of the individual engineers is different. The only basis upon which they are sued is the fact that each of them affixed his seal to the design documents. In my view, this is insufficient to establish a duty of care between the individual engineers and Edgeworth. The seal attests that a qualified engineer prepared the drawing. It is not a guarantee of accuracy. The affixation of a seal, without more, is insufficient to found liability for negligent misrepresentation. This is not convincing. The individual engineers were in exactly the same position, with respect to the test set out in Hedley Byrne, as was the firm. As interpreted in Haig v Bamford37 the test for liability for negligent misrepresentation requires only that the parties made the representation "with actual knowledge of the limited class that will use and rely on the statement"38 and that the representation was indeed reasonably relied upon: the party making the misrepresentation certainly need not guarantee the accuracy of their statement in order to be held liable.39 And it is difficult to argue that it is not reasonable to rely upon professional engineers to do their job, when the fact that they are professional engineers is attested to by the seal. The seal may not be a guarantee of accuracy, but it is certainly an invitation to reliance.40
- 11 -
IV.
DEFAULT RULES AND OPTIMAL CONTRACTS Despite the dubious doctrinal analysis, particularly in Edgeworth, the results in both cases can be
explained and largely justified on the basis of a relatively simple economic analysis of the Court's role in contractual interpretation. Economic analysis is particularly useful on the tort-contract boundary as it provides a unified framework in which tort and contract merge. The premise of economic analysis is that the law should promote transactions which maximize the joint wealth of the parties.41 In contract, it is evident that a voluntary exchange between two parties must increase joint wealth, as each party must believe herself to be better off, or she would not have agreed to the exchange. Contracts are needed because not all exchanges can be simultaneous, but contractual arrangements are prima facie efficient for the same reason that simultaneous exchanges are efficient. Because contracts by their nature contain at least some element of future performance circumstances may arise which make the contract more or less advantageous to one or both of the parties than at the time it was originally agreed to. If the parties could foresee and contract for every eventuality the contract entered into by the parties would nonetheless be optimal in the sense that it would maximize expected joint wealth because the risks of changed circumstances would be allocated, just as are the goods which are the subject of the exchange.42
But the parties will not be able to foresee all contingencies, and some contingencies may be sufficiently unlikely that even if they were foreseen they would not be worth negotiating over.43 When an unprovided for contingency arises the courts may be asked to fill the gap.44 In filling such a gap the courts should attempt to impose terms that the parties would have agreed to had they bargained about the matter themselves.45 Since the parties would have agreed to a wealth-maximizing contract, this amounts to saying - 12 -
that the courts should impose terms that would have been wealth maximizing at the time the contract was made.46
Even though in filling the gap the court may attempt to reproduce the terms the parties would have bargained for, it goes without saying that it would be preferable not to have a gap at all. Knowledge of both the industry in general and the particular circumstances of the parties is required to determine the optimal bargain for two particular parties, and clearly the parties have much more information in these respects than the courts. Shortly put, the parties know best what is in their own best interest. For this reason, when the parties have specifically addressed a matter in the contract, the courts should enforce the terms of the contract, even if those terms diverge from those that the court would have concluded were optimal.47
In tort law economic analysis suggests that the role of the court is to set rules which will minimize the costs of accidents, including the costs of precautions. This means that parties should take all those precautions, and only those precautions, which would prevent more harm than they cost.48 This can be recast in terms of a hypothetical bargain between the parties. If a precaution would prevent more harm than it would cost, a potential victim would be willing to pay the potential injurer some amount more than the cost of taking the precaution in return for the injurer's agreement to take that precaution. The fact that the precaution would cost less than the damage it would prevent gives room for a mutually beneficial bargain. However, if the precaution would cost more than it would save, the victim would prefer to bear the loss himself, as the amount he would have to pay the injurer to agree to take the precaution would be - 13 -
more than he would gain thereby.49
Thus both contract and tort converge to present a simple picture: when the parties have addressed an issue, the court should apply the contract as agreed to by the parties, and when the parties have not addressed the issue the court should fill the gap with the term which the court believes would have been optimal. This picture can readily be made more complex. For example, there is a well developed line of argument that when there is an asymmetry in information between the contracting parties, the court should apply default rules which will force one party to reveal its information. While the court does not impose terms which the parties would have bargained or — the party with the better information would not choose to reveal it — the "information-forcing" default rule nonetheless maximizes the joint gains to the parties.50 We can also consider markets which are not perfectly competitive, so that there is a surplus to trade to be split between the parties. This raises issues of how to fashion default rules to deal with bargaining power and strategic bargaining.51
The simple model is adequate for dealing with third-party beneficiary contracts in the context of the facts in cases like London Drugs and Edgeworth, as the markets in question are apparently competitive and there is no reason to think that there are different categories of employees who have varying aversions to assuming liability,52 but a different type of complication is raised: our model begs the question of how we determine whether there is a "gap" in the contract in the first place. The court must interpret the contract in order to determine whether there is a gap. It is notorious that in any interpretive exercise the interpretation will depend not only on the language to be interpreted, but also on the - 14 -
interpreter's presuppositions. In the case of contractual interpretation the relevant presuppositions are the court's view of the optimal contract. So, in the case of third-party beneficiary contracts, if the court is of the view that under the optimal contract between all the parties the third-party would be liable, it will be more likely to interpret an ambiguous exculpatory clause not to apply to the third-party. There is then a "gap" in the contract which the court will fill with what it believes to be the optimal term. Conversely, if the court is of the view that the defendant should not be liable, it will be more likely to interpret the limitation of liability to apply to the defendant. The point is not that the court will inevitably misinterpret the contract because of its own presuppositions. Rather, when interpreting a relevant but unclear term, the court has no choice but to use two sources of evidence as to the optimal term, both of which are imperfect: its own ex post analysis, and the unclear contractual term.
In so doing there is a spectrum both in terms of the court's confidence in its own judgment and in the clarity of the contract. If the contractual terms are clear, then the court should defer to the superior knowledge of the parties. If there are no terms which are at all applicable to the problem at hand, the court should interpret the contract in the way it believes to be optimal. The difficult case arises when the terms of the contract point weakly in one direction, but the court's assessment of the optimal contract points strongly in the other. In such a case the court must balance the strength of its view as to the optimal terms against the clarity of the intent expressed by the contractual terms.
This balancing process is dramatically demonstrated by the treatment of the defendant firm in Edgeworth. The basic presumption drawn from tort law is that the negligent party will be held liable for - 15 -
the damages caused thereby. This is broadly justifiable in terms of economic analysis by the principle that the party who can best avoid the loss should be liable. In a tort analysis this provides incentives to minimize the loss at least cost; in a contract analysis, had the parties contracted over the risk, they would have maximized their joint gains by placing liability on the person who can avoid the accident at least cost. In Edgeworth McLachlin J. proceeded from this basic premise in stating that the fact that the plaintiff reasonably relied on the negligent work of the engineers established a prima facie cause of action. 53
But she also argued that this general presumption was correct on the specific facts of the case: If the engineering firm is correct, then contractors bidding on construction contracts will be obliged to do their own engineering. In the typically short period allowed for the filing of tenders -- in this case about two weeks -- the contractor would be obliged, at the very least, to conduct a thorough professional review of the accuracy of the engineering design and information, work which in this case took over two years. The task would be difficult, if not impossible. Moreover, each tendering contractor would be obliged to hire its own engineers and repeat a process already undertaken by the owner. The result would be that the engineering for the job would be done not just once, by the engineers hired by the owner, but a number of times. This duplication of effort would doubtless be reflected in higher bid prices, and ultimately, a greater cost to the public which ultimately bears the cost of road construction. From an economic point of view, it makes more sense for one engineering firm to do the engineering work, which the contractors in turn are entitled to rely on, absent disclaimers or limitations on the part of the firm. In fact, the short tender period suggests that in reality this is the way the process works; contractors who wish to bid have no choice but to rely on the design and documents prepared by the engineering firm. It is on this basis that they submit their bids and on this basis that the successful bidder enters into the contract. The fact that the contractor may agree to exempt the party inviting tenders from liability for the design process does not suggest that it thereby should be taken to have exempted the engineering firm. In the scheme of things, it makes good practical and economic sense to place the responsibility for the adequacy of the design on the shoulders of the designing engineering firm, assuming reasonable reliance and barring disclaimers. The risk of liability to compensate third parties for design error will be reflected in the cost of the engineers' services to the owner inviting tenders. But that is a much better result than requiring the owner to pay not only the engineering firm which it retains, but indirectly, the additional engineers which all tendering parties would otherwise - 16 -
be required to retain. 54 This is a powerful argument that the optimal contract in this particular case would provide that N.D. Lea be liable, thereby reinforcing the broad presumption in favour of liability. It also provides a good reason to believe that the Ministry of Highways did not intend that the defendants be protected by the exclusionary clause. The party best able to avoid loss due to negligently prepared plans was clearly the defendant. If the Minister had accepted liability, rather than disclaiming it, it would undoubtedly have sued on its contract with N.D.Lea for any losses resulting from poor design; the Ministry would not have allowed N.D.Lea to disclaim liability to the Ministry for careless performance of its core contractual responsibilities. Since both parties would gain by entering into an optimal contract, we may also say that the defendants would have agreed to accept liability if transaction costs had been low enough to make an agreement possible.
While it is clear that the Court believed that the defendant firm would be liable on the optimal contract, the actual contract is also relevant because it reflects superior knowledge of the parties; and the contract in this case appears on its face to place the risk entirely on the plaintiff. But despite the apparently clear allocation of risk on a literal interpretation of the clause, there is reason to think that the clause does not deserve a literal interpretation. It is simply not believable that the plaintiff's contractor had in fact investigated every aspect of the works itself, had based its bid solely on its own knowledge, and had not relied on the specifications and plans supplied by the Ministry, as is stated by the exclusion of liability clause. Not only would it be impossible to amass this information in the limited time available, but if the clause were literally true there would have been no reason for the Ministry to pay N.D.Lea to prepare plans and specifications in the first place. The clause is clearly an attempt by the Minister to use the most forceful - 17 -
language possible in order to ensure that the contract would be effective in absolving it of liability; given, then, that we cannot take the words at face value, it becomes ambiguous whether they apply to absolve the defendant firm.
But even if this argument is correct in suggesting that the contract could not be taken literally, McLachlin J. did not use these or any other arguments to cast doubt on the clause itself in this manner; she simply dismissed it almost out of hand.55 This indicates that in striking a balance between the evidence of the contractual terms and the evidence supplied by its own view of the optimal contract, this Court has considerable confidence in its own ability to determine the optimal contract.
The treatment of the individual defendants in both cases can similarly be explained as a search for the optimal contract terms. La Forest J.'s decision in London Drugs is an extended discussion of the reasons why we would expect that in general, the optimal contract with ordinary employees would relieve them of liability. The specific points made by La Forest J. were that "the vicarious liability regime allows the plaintiff to obtain compensation from someone who is financially capable of satisfying a judgment"; "[s]econd, a person, typically a corporation, who employs others to advance its own economic interest should in fairness be placed under a corresponding liability for losses incurred in the course of the enterprise"; "third, the regime promotes a wide distribution of tort losses since the employer is a most suitable channel for passing them through liability insurance and higher prices"; and "[f]ourth, vicarious liability is also a coherent doctrine from the perspective of deterrence. [The employer] is in a much better situation than [the employees] to adopt policies...to prevent accidents of this type."56 I suggest that the first - 18 -
and second points are not convincing: a plaintiff will rarely pursue someone who is incapable of satisfying a judgment (and some individuals, notably professionals, do carry insurance), and fairness is an indeterminate standard, ill-suited to assessing commercial liability. However, the third and fourth points together are much more convincing. Transaction costs associated with buying insurance will generally be lower for a firm than for the individual employees. This is particularly apparent in cases such as London Drugs where it is clearly cheaper for the warehouse owner to carry insurance than to expect a relatively unsophisticated workforce which may have a high turnover rate to do so. And more care on the part of the employees is not the only way in which the likelihood of an accident can be reduced; the employer is in a better position to identify and implement systematic changes which may be even more effective in avoiding accidents.57 Further, the employees are almost certainly more risk-averse than the employer, and this implies that it is efficient for the employer to agree to bear part or all of the burden of losses caused by the employee, especially if the employee cannot purchase personal insurance.58 Ordinarily employees may be well placed to avoid an accident, but accidents will nonetheless occur, and when they do, these employees will be poorly placed to bear the loss. In view of this it is reasonable to think that had the parties contracted over the matter, the individual employees would not have been made responsible. This is confirmed by an important point, raised somewhat obliquely by La Forest J.: when the majority of the House of Lords allowed an employers liability insurer to recover an indemnity against a negligent truck driver in Lister v Romford Ice & Cold Storage Co59, "The effect of the....decision was promptly substantially nullified by a whole series of formal and informal agreements."60 In other words, the employees contracted out of the default rule imposing liability in tort, which is surely an indication that the default rule did not represent the contract the parties would have bargained for. - 19 -
The same analysis can be applied with respect to the individual engineers in Edgeworth, although as La Forest J. noted in his concurrence, the argument is weaker than in London Drugs because in this case the professional engineers are in a much better position to protect themselves, either contractually or through insurance, than were the individual defendants in London Drugs.
Two general observations may be made. Firstly, the best explanation for the result with respect to individual employees in both cases is that Court has been convinced by La Forest J.'s argument that there should be a presumption against ordinary employees being held liable. Secondly, in interpreting third-party beneficiary contracts, the Court appears to be attempting to impose what it believes to be the optimal contract terms, using whatever doctrinal tools come readily to hand. Iacobucci J.'s assertion that "intent of the parties" is central is misleading, at least to the extent that it suggests that the express terms of the contract are determinative, or even important. Similarly, McLachlin J.'s use of voluntary assumption of risk in London Drugs appears to have been no more than a convenient means of reaching the appropriate result in that particular case.
V.
PRINCIPLES AND CATEGORIZATION To turn to the first of these point, we must ask why the majority unwilling to explicitly adopt a
presumption which it is willing to strain so mightily to apply. The answer given in London Drugs that the other members of the Court were not willing to effect such a large change in the law.61 This obscures the degree to which the decisions were compatible and even complementary. If La Forest J. is correct that in the great majority of cases the employees are not the best risk bearers, and so would never agree to - 20 -
assume liability, and if, as I have argued, the Court as a whole is attempting to impose efficient contract terms, that is, the terms that the parties would have agreed to had the point been the subject of bargaining, then we should expect that the majority will consistently find that the employees are not liable. This is illustrated by the tendentious analysis in Edgeworth. The issue is not what the law is to be, but how it is to be stated.
I suggest that the approach of the majority in both cases evidences a preference for applying general principles on a case-by-case basis, rather than fashioning narrower categories of cases and specific rules or presumptions which apply in these categories. In London Drugs both Iacobucci J. and McLachlin J. proceeded on the basis of broad tort and contract principles, whereas La Forest J. narrowed the focus to the liability of employees. In rejecting La Forest J.'s approach Iacobucci J. remarked that "Our law of negligence has long since moved away from a category approach when dealing with duties of care. It is now well established that the question of whether a duty of care arises will depend on the circumstances of each particular case, not on predetermined categories and blanket rules as to who is, and who is not, under a duty to exercise reasonable care."62
In theory the case-by-case application of broad principles can give perfect results (assuming the underlying principle is a good one) without resort to categorization. Stating the law would be simple — "impose the wealth maximizing contract" — but the trick would be in its application. To go from the broad rule to the correct result in a particular case can be a subtle and difficult process as there are myriad factors which vary from case to case which affect the goal of joint wealth maximization. This is evident both in La - 21 -
Forest J.'s decision in London Drugs and in McLachlin J.'s treatment of the defendant firm in Edgeworth. To apply a broad rule properly requires a thorough appreciation of these factors and their interaction with the underlying principle: in other words, it requires expertise. The number of experts who can correctly apply the principle to any given situation will certainly be relatively small and of necessity the law must be administered largely by those who are less than expert. This means that the application of broad principles to particular fact patterns will regularly lead to error as a result of the misapplication of those principles.63
The currently fashionable call for a more contextual application of the broad principles is one response to this problem. The failure to reach a correct result after a good-faith effort to apply a correct broad principle can usually be attributed to a failure to appreciate the relevance of one or more factors: in other words, a lack of sufficient contextualization. But while it is undoubtedly true that broad principles require a thoroughly contextual application in order to arrive at correct results, it is unlikely that calling for greater contextualization will solve the problem of errors caused through the inappropriate application of the principles, for this is simply to ask non-experts to become experts. The Supreme Court has explicitly recognized its own lack of sophistication in various areas of administrative law which makes it ill-suited to accurately apply the broad principles involved in those areas in a properly contextual manner.64 In view of this the lower courts can hardly be expected to be sufficiently expert in the vast body of law remaining in the sole jurisdiction of the courts to be able to reliably apply a properly contextual approach in all cases. Perhaps more to the point, we cannot expect the lower courts to engage in the imaginative application of doctrine demonstrated by Edgeworth. To ask them to do so would result in unpredictable results with no - 22 -
guarantee of justice in individual cases.
An appropriate classification system can alleviate the problem of lack of expertise by using easily identified fact patterns which are not directly relevant to the underlying principle to categorize cases. These fact patterns are proxies for factors which are directly relevant but which are more difficult to identify. For instance, relative risk aversion and informational asymmetries are significant in economic analysis and these provide a basis for distinguishing in the legal treatment of individuals and corporations.65 Once the categories are established specific rules can then be applied which mirror the underlying principle in the context of the specific category. For classification to be helpful, the rule which applies in each category must be easier to apply than the underlying principle. It does no good to divide contract law into contracts affecting individual employee contracts and those affecting firms and then apply the same difficult principle, "maximize wealth" in both cases. Further, the fact patterns which define the categories must also be readily identified, or miscategorization will lead to errors even if the rules themselves are entirely appropriate.
And for
classification to lead to the correct results, the categories must be defined so that the specific rule leads to the correct result when applied to the cases in the corresponding category. In other words, the categories must be well defined, the rules which apply must be well defined, and the rules and categories must correspond accurately.
This is to ask the impossible. We can hope for categories and the corresponding rules to mesh and give the correct result only because the salient facts are proxies for underlying factors. But proxies are - 23 -
necessarily imperfect, since proxies are necessarily different from the factors they represent. Not all individuals are more risk averse or less informed than all corporations. Application of the law based on the proxies rather than the direct application of underlying principles will therefore inevitably lead to incorrect results in some cases as the category is under- or over-inclusive. Alternatively, we may note that the rule which applies in a particular category, must, in order to be more readily applicable than the true principle, be no more than a proxy for and simplification of the true principle. Because of this its range of application is necessarily limited.
In summary, if the law simply states a broad principle which is applied on a case-by-case basis, errors will result because of misapplication of the principle by less than expert interpreters. On the other hand, if the law consists of easily applied specific rules which apply in readily identified factual situations, errors will result because the classifications are imperfect and cannot always accurately reflect the underlying principles which they are intended to mirror. Apart from the disappointed expectations of the parties concerned, such errors increase the cost of contracting in slightly different ways. Errors due to the misapplication of broad principles will introduce uncertainty into the outcome of particular cases, thus increasing litigation costs.66 Classification errors can be expected to increase transaction costs as the parties are forced to bargain around predictable deviations from optimal default rules.
The seduction of a contextual application of broad principles is that, in theory, it is always possible to arrive at the correct result. This is in contrast to a categorical system, where errors are inevitable. Perhaps for this reason there is a tendency for those who feel themselves expert in an area, such as - 24 -
academics, and to an extent the Supreme Court, to advocate contextual application of broad principles. This ignores the trade-off is between the flexibility to do justice in all cases against providing guidance to lower courts which will result in justice in most cases.67
The Supreme Court has not abandoned the task of providing guidance to the lower courts to the extent suggested by Iacobucci J.'s remark. It is true that in C.N.R. v Norsk Pacific Steamship Co.68 the Court rejected the return to a categorical approach advocated by the House of Lords in Murphy v Brentwood D.C.69. To the extent that Murphy represented a preference for logic over justice70 it is certainly not attractive and it may also be that Iacobucci J.'s stated rejection of categorization is a reaction to outdated categorization. However, it is wrong to conclude that there is no alternative but to apply broad principles on a case-by-case basis. Rather, as was recognized by both McLachlin J. and La Forest J. in the course of rejecting Murphy, the better approach is to develop categories which are both administrable and just: as McLachlin J. remarked "the search should not be for a universal rule but for the elaboration of categories where recovery of economic loss is justifiable on a case-by-case basis."71 Categorization was also central to Kamloops (City) v Nielsen72, a case which made initial inroads on the rule against economic loss, as Wilson J. made it clear that her analysis turned on the fact that the defendant was a public authority, and that Kamloops did not imply that the same liability should be extended to other bodies or individuals.73
Further, it is wrong to characterize La Forest J.'s decision as the application of a blanket principle to a predetermined category. Rather, he established a presumption which applies to an open category. The presumption is strongest in the paradigm case, represented by London Drugs, involving ordinary - 25 -
employees in commercial case. Even in such a case the presumption may be rebutted through express agreement with the employee. La Forest J. suggests both that reasonable reliance on ordinary employees may be possible even without express agreement in other circumstances,74 and that reliance on a special type of employee may be reasonable even in commercial cases.75 Thus the presumption against liability is not conclusive, nor is the scope of its application rigidly determined. La Forest J.'s approach gives guidance while allowing flexibility.
Of course, to the extent that La Forest J.'s approach allows flexibility, it provides less guidance, and to the extent that it categorizes it reduces flexibility. But there is no reason to believe that the process of developing categories is a zero-sum game, where errors due to miscategorization are inevitably balanced by errors due to misapplication of principle. Net gains may be had in those situations where it is possible to establish categories and corresponding rules or presumptions which closely track the underlying principles. The debate should not be whether categorization is useful per se but whether it does more harm than good in a particular context.
Further, since this case arises on the tort-contract boundary contracting is possible and if the parties wish they can contract so that the employees are liable. Viewed from this perspective La Forest J.'s position is not a radical change in tort law which will dramatically affect liability but is a shift in background rules which should make it easier for all the parties to arrive at mutually beneficial contracts. This means that as a problem in classification, the majority approach is only sensible if they are of the view that the cost of contracting around the general presumption that employees are not liable in those cases where the - 26 -
presumption is wrong will outweigh the increased litigation costs resulting from the uncertainty of generated by a more generalized approach. This would require a significant number of cases in which ordinary employees should be liable and relatively high costs of contracting around the presumption to the contrary. On the whole, it seems likely that these requirements are not met, and there are net gains to be had from explicitly adopting La Forest J.'s presumption against liability of ordinary employees rather than applying it on a case-by-case basis.
This leads to the observation that it is not necessary that a presumption be right more often than it is wrong in order for it to be useful. If the costs of contracting around a presumption are low, and the presumption reduces litigation costs, then the increase in transaction costs due to the marginally accurate presumption may be outweighed by a decrease in litigation costs. This is relevant to the second general observation made earlier, that the Court was very aggressive in imposing its view of the optimal contract in Edgeworth. Even if the Court's judgment is good this attitude creates some problems. The greater the confidence the court has in its own judgment, the more difficult it will be to contract in a manner contrary to that judgment. Transaction costs may be lowered for parties whose optimal contract corresponds with the court's view of the optimal contract, but they are increased for parties who wish to contract away from the terms which would be imposed by the court. At the extreme, if the court is so confident of its own view that it will impose that view in the face of any contractual language, then transaction costs could increase significantly even if the court is in fact usually right, as reaching the optimal contract becomes impossible in those cases where the court is wrong. A court which is less aggressive in imposing its own view may make some errors through overly literal interpretation, but at the same time some errors due to mistakes - 27 -
in the court's assessment of the optimal terms will be avoided.
This is a tension which is particularly important in the context of third-party beneficiary contracts, which lie on the tort-contract boundary. In paradigm tort cases, such as accidents between strangers, bargaining is impossible. In establishing the hypothetical optimal contract in such cases the court must be primarily concerned with getting the right result, as the parties cannot bargain around it. In contrast, in contract law the adage that it is more important that the law be certain than that it be right is particularly applicable,76 and the parties can and do bargain around unsatisfactory default rules or presumptions.77 In the case of third-party beneficiary contracts striking the right balance is particularly difficult. Bargaining through the contractual chain is possible so that certainty in the law is desirable to provide a backdrop for that bargaining; but adding an extra link to the contractual chain will increase transaction costs, thereby impeding bargaining and so increasing the importance of correct judicial analysis. As La Forest J. argued, a general presumption that ordinary employees will be liable may be very difficult to remedy via contract.78
While striking the correct balance will be a difficult task, the cavalier attitude to the contractual terms displayed by the Court in Edgeworth is an extreme position, more appropriate to a pure tort case than to a situation in which bargaining is possible. Bargaining could be facilitated in two ways. Firstly and most obviously, the Court should have paid mor attention to the contractual term, even if only to accord it a non-literal interpretation for the reasons suggested. It is difficult for the parties to bargain if the Court will ignore the terms. Secondly, while a broad general presumption that third party firms (as opposed to - 28 -
individual employees) are not covered by a limitation of liability clause may often be wrong, a freewheeling case-by-case interpretation of the contract terms will lead to the wrong result as well; it seems likely that the articulation of some general presumption, if only a weak one, will create a worthwhile increase certainty and a corresponding reduction in ligation costs.
VI.
CONCLUSION I have argued that the decisions of the Supreme Court in both London Drugs and Edgeworth are
best explained as attempts by the Court to impose optimal contract terms on the relevant parties, including those claiming third-party beneficiary status. La Forest J.'s decision in London Drugs establishes that an optimal contract will in general absolve ordinary employees from liability in negligence to their employer's customer. Not only is his argument convincing, it appears to have convinced the rest of the Court: unfortunately the majority has been unwilling to adopt La Forest J.'s position explicitly, and prefers to apply his presumption against the liability of ordinary employees implicitly in the course of a case-by-case application of broad tort and contract principles. This leads to uncertainty in the law and may lead to injustice in particular cases. The Court's sensible remarks in other contexts about the need to develop appropriate categories lead one to hope that the misguided reluctance to apply a categorical approach to employees liability to their employer's customers will eventually be overcome.
In attempting to determine the optimal contract terms the Court has no choice but rely to some extent on its own view of the optimal terms. However, the approach the majority has taken is unduly aggressive. The law could be made more certain if the Court would establish broad, if weak, presumptions - 29 -
regarding liability of non-employee third-parties; and the bargaining process would be facilitated if the Court would demonstrate a modicum of respect for the contract terms.
In London Drugs and Edgeworth the Court has demonstrated an appreciation of and willingness to apply economic arguments in order to arrive at commercially sensible results. If all cases were to be decided by the Supreme Court, the situation would be quite satisfactory. Unfortunately, the Court has been insufficiently attentive to its role in providing guidance to lower courts and in helping parties express their intentions in a way which will understood and respected by the courts. ****** *.
Assistant Professor, Faculty of Law, University of New Brunswick. The author was a clerk to
Madam Justice McLachlin at the time that London Drugs was decided, but was not involved in any aspect of the decision. I would like to thank Ed Veitch and Don Fleming and an anonymous referee for helpful comments on earlier drafts. I retain responsibility for errors or omissions. 1.
97 D.L.R.(4th) 261, [1992] 3 S.C.R. 299, hereinafter cited to D.L.R.
2. [1993] 3 S.C.R. 206, 107 D.L.R.(4th) 169 hereinafter cited to D.L.R.. Leave to appeal in Edgeworth was granted on 2 July 1992 (141 N.R. 396n), while London Drugs was still under consideration. 3. The relevant clause is 11(b): "The warehouseman's liability on any one package is limited to $40 unless the holder has declared in writing a valuation in excess of $40 and paid the additional charge specified to cover warehouse liability." 4.
Himself, L'Heureux-Dubé, Sopinka and Cory JJ.
5.
Supra n.1 at 335.
- 30 -
6.
Id at 366.
7. Id at 367. This, of course, is that major holding of the case, as the conclusion that the third party employees could take advantage of the limitation of liability clause depended only on the intention of the parties that they should be able to do so without the artifices referred used by the English courts in The Eurymedon, [1974] A.C. 154, and the cases leading up to it. Iacobucci J. added the further requirement that "the employees (or employee) seeking the benefit of the limitation of liability must have been acting in the course of their employment and must have been performing the very services provided for in the contract between their employer and the plaintiff (customer) when the loss occurred." (at 367). From this it would appear that if the parties to the contract expressly agreed that the limitation of liability should apply to the employees even if they were performing services other than those stipulated in the contract, the employees would not be able to benefit from the clause. As pointed out by Marvin Baer, in his Comment on London Drugs (1993) 72 Can. Bar Rev. 385 this restriction "makes little commercial sense in terms of the available insurance" (at 401) and it is difficult to understand why the express intention of the parties should be defeated in any event. 8.
Id at 369.
9. This is in contrast to the decision of La Forest J. who held that in the circumstances the employees owed no duty at all to the owner of the damaged property. His decision is discussed in more detail infra in the discussion of the liability of the individual defendants. 10.
Supra n.1 at 321
11.
Id.
12. Id at 322, citing Wallace J.A. in the Court of Appeal quoting Purchas L.J in Pacific Associates v Baxter [1990] 1 Q.B. 993 (C.A.) at 1011. 13.
Id at 323.
14.
Id at 322
15. Id: "In short, the court, where appropriate, may as a matter of policy imply a term in a particular type of contract, even where it is clear that the parties did not intend it." 16.
Id at 341.
17.
Id at 267.
18.
Id at 313.
19.
Id at 313.
- 31 -
20.
Id at 312.
21.
See the trial decision (1989) 37 C.L.R. 152 at 157.
22. See Catre Industries Ltd. v Alberta (1989) 36 C.L.R. 169 (Alta.C.A.) dismissing the contractors claim against the province on essentially the same facts as in Edgeworth. 23. Edgeworth lost both on a pre-trial motion and on appeal, with the Court of Appeal holding that when the design, plans and specifications were adopted by the Ministry of Highways these ceased to be representations made by N.D.Lea, "at least insofar as proximity for the purposes of a duty of care with respect to economic loss is concerned" (53 B.C.L.R.(2d) 180 at 183). 24.
Herself and Sopinka, Gonthier, Cory, Iacobucci, Major JJ.
25. [1964] A.C. 465, as adopted by the Supreme Court in Haig v Bamford, [1977] 1 S.C.R. 466, 72 D.L.R.(3d) 68; see paras 3-4 of Edgeworth. 26.
Supra n.2 at 174.
27.
Id at 178.
28.
Supra n.1 at 369.
29.
Id at 369.
30.
Id at 322.
31.
Id at 369.
32. In applying her analysis to the facts McLachlin simply adopted the reasoning of McEachern C.J.B.C., Hinkson J.A. and Wallace J.A. which emphasized the effect of the clause in allocating risk rather than the fact that the defendants were ordinary employees. For instance McEachern C.J.B.C. remarked (70 D.L.R.(4th) 51 at 71) that "The most significant fact about this case is that the employees were acting in a contractual setting in which the plaintiff had voluntarily agreed with their employer that the latter would store and care for the transformer, exercising the 'reasonable care and diligence' which the law requires, and on terms that his right of recovery for breach would be limited to $40." 33. "Acceptance" of risk might seem the better term here as it implies contractual assignment of risk, as opposed to imposition of risk by the court. The difficulty arises because the case arises on the tortcontract boundary where neither term is entirely appropriate. McLachlin J. uses "assumption of risk" because of the self-consciously tort-based analysis which she adopts and I will do the same for reasons of consistency. 34.
See the trial decision, supra n.21 at 155. - 32 -
35.
Supra n.2 at 174.
36.
Id at 174.
37.
[1977] 1 S.C.R. 466, 72 D.L.R.(3d) 68.
38.
Id at D.L.R. 74.
39. This was made quite clear by Lord Denning in Esso Petroleum v Marden [1976] 1 Q.B. 801 (C.A.) at 818. 40. It may be suggested that the situation of the individual engineers and the firm may be distinguished by the requirement of Hedley Byrne that there be a voluntary assumption of responsibility in order to give rise to liability and that the firm may be taken to have assumed the responsibility while the engineers did not. However, neither the firm nor the engineers explicitly assumed responsibility. Certainly the assumption of responsibility can be and normally is inferred from the circumstances (see the remarks of Lord Reid in Hedley Byrne at 583), and normally such an inference would normally be drawn in the case of a professional rendering paid services (see Haig v Bamford at 80. See also David Allen, "Hedley Byrne Revalued" (1989) 105 L.Q.R. 511 for a discussion of recent developments on this point). In any event, if the assumption of responsibility is inferred by the court then speaking of voluntary assumption of responsibility is not very helpful unless we know under what circumstances such an inference will be drawn. In Smith v Bush and Harris v Wyre Forest District Council [1989] 2 W.L.R. 790 (H.L.) Lord Griffiths stated that "The phrase 'assumption of responsibility' can only have real meaning if it is understood as referring to the circumstances in which the law will deem the maker of the statement to have assumed responsibility to the person who acts upon the advice" (at 813). When used in this sense it is apparent that "assumption of risk" is no more than the expression of a conclusion, which (assuming no explicit assumption of responsibility) is arrived at for other reasons. I suggest that while the majority's discussion of the engineer's liability is conclusory, it would have been no less conclusory had they referred to voluntary assumption of responsibility. 41. More accurately, the transaction maximizes joint utility, which differs from wealth both because one or both parties may be risk averse and because non-pecuniary goods may be involved. In the commercial context, and for the purposes of our discussion, it is satisfactory to speak of wealth maximization, with specific reference to risk aversion where necessary. It is also more precise to say that economic analysis suggests that the goal of the court should be to induce utility maximizing transactions. In some circumstances this goal may require the court to impose contractual terms which are not themselves utility maximizing. Again, for our purposes this complication may be ignored: see the discussion at infra at n.50,51 and the accompanying text. For accessible discussions of the relationship between tort and contract law from an economic perspective see Cooter, Unity in Tort, Contract, and Property: The Model of Precaution, 73 Cal.L.Rev. 1 (1985) and Bishop The Contract-Tort Boundary and the Economics of Insurance, (1983) 12 J.Legal Stud. 241. Note that one need not believe that efficiency is or should be the only goal of law in order to find economic analysis useful so long as one accepts that it is a legitimate - 33 -
and important objective. I suggest that in the context of commercial transactions efficiency should be a dominant concern. 42. This is known as a complete contingent contract. Barton, The Economic Basis of Damages for Breach of Contract, 1 J.Legal Stud. 277 (1972) shows that such a contract results in joint profit maximization given equivalent knowledge of risks by both parties. 43. This description of the role of the courts is obviously sketchy and incomplete. Another reason for incompleteness is that one parties may not to be able to verify whether a particular contingency has arisen. For instance, a complete contract might specify that a purchaser would pay more if the seller's cost of production went up, but the purchaser might be unwilling to enter into such a contract because s/he would have no way of verifying whether the purchaser's costs had in fact gone up. A more general statement of the appropriate role of default rules is that they should induce the parties to act as they would under a complete contingent contract: see generally, Shavell, Damage Measures for Breach of Contract 11 Bell J. Econ. 466 (1980); Shavell, The Design of Contracts and Remedies for Breach 99 Q.J.Econ. 121 (1984). 44. Renegotiation is another option which may be particularly important in relational contracts. There is a considerable body of scholarship dealing with incompleteness in the context of relational contracts: see for example Alan Schwartz, Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies, 21 J.Legal Stud. 271 (1992); Baird,Self-Interest and Cooperation in Long-Term Contracts, 19 J.Legal Stud. 583 (1990). 45. Textbook statements of this position are found in Posner Economic Analysis of Law (4th ed. 1992) at 93: "The task for a court asked to interpret a contract to cover a contingency that the parties did not provide for is to imagine how the parties would have provided for the contingency if they had decided to do so." See also Posner & Kronman Economic Theory and Contract Law, in Posner & Kronman eds., The Economics of Contract Law, saying "many substantive rules of contract law are simply specifications of the consequences of some contingency for which the contract makes no express allocation. If the parties are satisfied with the way in which the rule allocates the risk of that contingency, they have no need to incur the expense of writing their own risk-allocation rule into the contract" (at 6). For applications of this approach see Easterbrook and Fischel The Corporate Contract (1989) 89 Colum. L.R. 1416; Douglas Baird Self-Interest and Cooperation in Long-term Contracts (1990) 19 J.Legal Stud. 583; Clayton P. Gillette, Commercial Relationships and the Selection of Default Rules for Remote Risks 19 J.Legal Stud. 535 (1990); Goetz & Scott The Mitigation Principle: Toward a General Theory of Contractual Obligation (1983) 69 Va. L.R. 967; Epstein Beyond Foreseeability: Consequential Damages in the Law of Contracts (1989) 18 J.Legal Stud. 105; Alan Schwartz, A Theory of Loan Priorities (1989) 18 J.Legal Stud. 209. For criticisms of this view see the articles mentioned infra at n.50,51. 46. The courts cannot, of course, maximize wealth after the fact, as the breach is already occurred and all the court can do is redistribute the wealth. The court should create rules which would induce parties to - 34 -
act as they would if they had entered into a complete contingent contract which they would be held to. Another important goal of contract law generally is to prevent parties from engaging opportunistic breach; that is, since contracts generally involve sequential performance of obligations an opportunity will arise for one party to take advantage of the other by refusing to perform its obligations, and preventing such behaviour is the reason that the law enforces contractual obligations. For a discussion of incomplete contracts which emphasizes this aspect of the role of contract law see Benjamin Klein & Roy W. Kenney, An Economic Theory of Contract Law, (Law and Economics Working Paper, Univ. of Toronto, 1989). 47. There are of course situations in which the courts will decline to enforce the contract as written and "consumer protection" legislation may similarly restrict terms which may be enforced. Economists are generally critical of such restraints on freedom of contract: see eg Sykes The Doctrine of Commercial Impracticability in a Second Best World (1990) 19 J.Legal Studies 43; Priest A Theory of the Consumer Product Warranty, 90 Yale L.J. 1297 (1981). This debate is not germane to this article and I will proceed on basis that the terms in question are such as would be enforced by the courts. For instance, the Court in Edgeworth was inclined to find the corporate defendants liable, but a sufficiently clear exculpatory clause would surely have been upheld. 48. The best system would minimize all costs including administration costs. The seminal work is Calabresi Some Thoughts on Risk Distribution and the Law of Torts, 70 Yale L.J. 499 (1961). See also Calabresi The Costs of Accidents: A Legal and Economic Analysis (1970). More recent standard works are Landes & Posner, The Economic Structure of Tort Law (1987) and Shavell, Economic Analysis of Accident Law (1987). 49. This point is made most famously in Coase, The Problem of Social Cost 3 J. Law & Econ. 1 (1960). This idea that tort law mimics the outcome of such hypothetical bargaining may seem particularly suspect in the case of personal injuries, but to enter into the merits of the economic view of tort law in general is beyond the scope of this essay (see the discussion in the Symposium on Efficiency as a Legal Concern, 8 Hofstra L.R. 485 (1980)). I will simply suggest that this analysis is reasonably persuasive where the harm done is purely monetary, as in Edgeworth, or where the damage is clearly fully compensable, such as the damage to the transformer in London Drugs. 50. See Ayres and Gertner, Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, (1989) 99 Yale L.J. 87 point out that the "what the parties would have wanted" approach is premised on the notion that the primary reason for incompleteness is high contracting costs. They argue that an important role for default rules, and the rule in Hadley v Baxendale in particular is to prevent parties from strategically withholding information. If the information is not revealed the party with the better information will get a larger piece of a smaller pie, which maximizes the gains to that party, but does not maximize joint gains. Bebchuk & Shavell Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v Baxendale (1991) 7 J.L.Econ. & Org. 284 develop this argument in a formal model. See also Bishop The Contract-Tort Boundary and the Economics of Insurance, (1983) 12 J.Legal Stud. 241 making a similar point in suggesting that tort and contract doctrine will not converge into one grand doctrine of obligations, as is sometimes suggested, because of the role of contract doctrine - 35 -
in ensuring efficient exchange of information. See Epstein Beyond Foreseeability supra n.45 arguing that the rule in Hadley v Baxendale is in fact what the parties would have wanted (although Epstein does not take issue with the general point that information forcing default rules may sometimes be desirable). The points made by Ayres & Gertner and Bishop are valid, and the analysis in this paper is therefore confined to cases in which high transaction costs are in fact the reason for incompleteness. I suggest that this will often be a significant problem in cases involving contractual chains and that it is the most significant problem in cases such as Edgeworth and London Drugs (see the further discussion in the text). 51. This issue is explored in Johnston Strategic Bargaining and the Economic Theory of Contract Default Rules (1990) 100 Yale L.J. 615 and Ayres & Gertner Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules (1992) 101 Yale L.J. 729. 52. In Strategic Contractual Inefficiency supra Ayres & Gertner concede that "The hypothetical contract analysis ["that the parties would have wanted approach] will produce efficient contractual rules in the broad variety of contexts where parties have symmetric information about all aspects of the transaction (including the legal rule. In thee contexts, only the costs of contracting will induce obligational incompleteness, and majoritarian rules will ordinarily minimize the costs of contracting and failing to contract for efficient obligations" (at 765). 53.
Supra n.2 at 173.
54.
Id at 177.
55.
See the discussion supra at n.35 and accompanying text.
56.
Supra n.1 at 282-3.
57.
Although if the workplace is unionized the union may be well placed to serve such a function.
58. For a thorough discussion of incentive effects of vicarious liability see Alan O. Sykes The Economics of Vicarious Liability (1984) 93 Yale L.J. 1231. 59.
[1975] A.C. 555.
60. Per La Forest J. in London Drugs supra n.1 at 287 referring to Atiyah Vicarious Liability (London: Butterworths, 1967) at 426-7. For another judicial recognition of the fallout of Lister see the decision of Lord Denning in Morris v Ford Motor Co Ltd. [1973] 1 Q.B. 792. 61. Iacobucci J. stresses throughout the importance of incremental change. McLachlin J. noted that "While I confess to great admiration for the scholarship and good sense that [the reasons of Justice La Forest] display, my concerns about the magnitude of the change they would introduce to the Canadian law of tort and the difficult questions they raise prevent me from agreeing with them" (supra n.1 at 320).
- 36 -
62.
Supra n.1 at 337.
63. See Isaac Ehrlich and Richard A. Posner An Economic Analysis of Legal Rulemaking (1974) 3 J.Legal Stud. 257 for a detailed treatment of the trade-off between rules and standards (standards represent underlying principles and rules, like narrow categories or law, reject some relevant factors in return for ease of administration). Jay M. Feinman The Jurisprudence of Classification (1989) 41 Stan. L.R. 661 argues that the problems with traditional classification systems are such that classification itself should be rejected in favour of a paradigmatic approach. While Feinman's discussion of the types of system of classification and their problems is very useful , his proposed paradigmatic approach is not a solution to the problems he identifies. Kuhn's brilliant monograph on The Structure of Scientific Revolutions is primarily a description of the way in which scientists do in fact think; it does not advocate a new approach to scientific problems. While a thorough discussion is beyond the scope of a footnote, this suggests that in application to law, our present classification systems are already largely based on paradigms. A more conscious application of this approach is unlikely to change very much. In particular, there is no prospect that problems which now appear to be on the border of traditional categories will become any more tractable if they are framed as partaking equally of two conflicting paradigms. Ultimately, Feinman's approach is simply a call for greater contextualization. See also Roscoe Pound Classification of Law (1924) 37 Harv. L.R. 933 for a largely descriptive account of classification systems. 64.
See e.g. Pezim v British Columbia (Supreintendant of Brokers) 23 June 1994 (unreported).
65. Steven Shavell On Liability and Insurance 13 Bell J. Econ. 120 (1982) shows that in the presence of effective insurance markets it is inefficient to adjust damages to reflect relative risk aversion. The present article assumes that there are inefficiencies in the insurance market: see infra n.56 and accompanying text. 66. Litigation is more likely when the parties subjective estimates of the probability that the suit will be successful diverge (Richard Posner An Economic Approach to Legal Procedure and Judicial Administration (1973) 2 J.Legal Stud. 399; John P Gould The Economics of Legal Conflicts 2 J.Legal Stud. 279) and divergent estimates are more likely when the law is uncertain. 67. The debate as to the appropriate level of generality of legal rules and presumptions is closely related to the debate over whether the courts should apply a majoritarian or particularized approach in applying the "what the parties would have wanted approach" to default rules; that is, in filling a contractual gap should the courts apply the rule which most parties would have bargained for, or should it apply the rule which the particular parties in issue would have bargained for. For the observation that most scholarly work tends to advocate an increasingly particularized approach, and a criticism of this suggesting that overly particularized rules interfere with the paries ability to contract around these rules, see Robert E. Scott, A Relational Theory of Default Rules for Commercial Contracts 19 J.Legal Stud. 597 (1990). An extensive elaboration of a similar point is found in Charles J. Goetz & Robert E. Scott The Limits of Expanded Choice: An Analysis of the Interactions Between Express and Implies Contract Terms (1985) 73 Cal.L.Rev. 261. - 37 -
68.
(1992) 91 D.L.R.(4th) 289, [1992] 1 S.C.R. 1021, hereinafter cited to D.L.R..
69.
[1991] 1 A.C. 398. Murphy is disapproved by La Forest J. at 303 and by McLachlin at 371.
70. See the speech of Lord Keith at 472: "The decision [in Anns] is capable as being regarded as affording a measure of justice, but as against that the impossibility of finding and coherent and logically based doctrine behind it is calculated to put the law of negligence into a state of confusion defying rational analysis." 71. Supra n.68 at 365. McLachlin J. remarked at 370 that "As more cases are decided, we can expect further definition on what factors give rise to liability for pure economic loss in particular categories of cases." La Forest J. agreed that "a broad bar on recovery of pure economic loss" should be rejected; he identified "at the very least" three types of cases involving economic loss, and proposed barring only what he called contractual relational economic loss (302-3). 72.
(1984) 10 D.L.R.(4th) 641, [1984] 2 S.C.R. 2.
73.Id at D.L.R. 679-681. 74.
Supra n.1 at 313.
75.
Id at 312.
76.
Of course, it would be best if the law were both certain and correct.
77.
See Epstein Beyond Foreseeability supra n.45 for an elaboration of this point.
78. The fall-out from Lister discussed supra n.60 is an example in which the employees did not fact bargain the presumption of liability, but this occurred in the context of a strong union and a relatively common problem.
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