The American Bronze decision, discussed in the previous chapter, illustrates the diversity and flexibility of remedies in Article 2 of the U.C.C. for the recovery of damages caused by the breach of sale agreements. The remedies for sellers and buyers are set forth in parallel and symmetrical fashion, with the exception of the buyer’s remedy for the seller’s breach of an express or implied warranty which for obvious transactional reasons has no counterpart seller’s remedy. Can you see why? Most importantly from a comparative standpoint-it allows for the unilateral termination of the contract by the victim of an anticipatory repudiation by the counter-party, a remedy unavailable to this day under the Spanish and Spanish influenced codes as was also discussed in the preceding chapter.
In connection with this unilateral termination, Article 2 sets forth two sets of remedies: the first relies on an actual purchase or sale (depending upon who is the aggrieved party) and the second on a hypothetical purchase or sale (also depending upon who is the aggrieved party).
The third remedy is judicial and subsidiary in nature: it is available to the party who can prove in court that, having chosen the remedy of resale or re-purchase, the recovery fell short of what he would have recovered had the defendant fully performed his contractual obligations. The fourth remedy is also judicial and also provides damages but is only available to buyers who can prove the seller’s breach of the express or implied contractual warranties provided by the U.C.C.
As will become apparent throughout this chapter, the aggrieved party’s power to terminate contracts extra judicially is at the root of the variety and flexibility of remedies found in the U.C.C. and United States case law. The following provisions on actual and hypothetical resales and re-purchases or covers as well as on the action for the price and for breach of warranty are transcribed to facilitate the subsequent discussion of their meaning in case law and commentary. The reader is encouraged to return to them during the ensuing discussion
According to § 2–706 (1), the first remedy available to the seller allows him to recover the difference between the contract price and the resale price of the goods in an actual, substitute sale.
§ 2–706. Seller’s Resale Including Contract for Resale.
(1) Under the conditions stated in Section 2–703 on seller’s remedies, the seller may resell the goods concerned or the undelivered balance thereof. Where the resale is made in good faith and in a commercially reasonable manner the seller may recover the difference between the resale price and the contract price together with any incidental damages allowed under the provisions of this Article (Section 2–710), but less expenses saved in consequence of the buyer’s breach.
(2) Except as otherwise provided in subsection (3) or unless otherwise agreed resale may be at public or private sale including sale by way of one or more contracts to sell or of identification to an existing contract of the seller. Sale may be as a unit or in parcels and at any time and place and on any terms but every aspect of the sale including the method, manner, time, place and terms must be commercially reasonable. The resale must be reasonably identified as referring to the broken contract, but it is not necessary that the goods be in existence or that any or all of them have been identified to the contract before the breach.
(3) Where the resale is at private sale the seller must give the buyer reasonable notification of his intention to resell.
(4) Where the resale is at public sale
(a) only identified goods can be sold except where there is a recognized market for a public sale of futures in goods of the kind; and
(b) it must be made at a usual place or market for public sale if one is reasonably available and except in the case of goods which are perishable or threaten to decline in value speedily the seller must give the buyer reasonable notice of the time and place of the resale; and
(c) if the goods are not to be within the view of those attending the sale the notification of sale must state the place where the goods are located and provide for their reasonable inspection by prospective bidders; and
(d) the seller may buy.
(5) A purchaser who buys in good faith at a resale takes the goods free of any rights of the original buyer even though the seller fails to comply with one or more of the requirements of this section.1
If § 2–706 requires an effectively executed resale of the goods by the aggrieved seller, § 2–708 gives the seller the option to hypothetically resell and calculate damages as if he would have actually resold the goods.2 Therefore, under this provision the seller has the right to recover the difference between the contractual price and the market price he would have received if the goods were sold in due contractual time and place. Additionally, this formula allows the seller to suspend production of the contractual goods.
§ 2–708. Seller’s Damages for Non-acceptance or Repudiation.
(1) Subject to subsection (2) and to the provisions of this Article with respect to proof of market price (Section 2–723), the measure of damages for non-acceptance or repudiation by the buyer is the difference between the market price at the time and place for tender and the unpaid contract price together with any incidental damages provided in this Article (Section 2–710), but less expenses saved in consequence of the buyer’s breach.3
As we mentioned earlier, the third formula is subsidiary to the one discussed above; it pertains to the profits that the seller would have received according to § 2–708(2). As a subsidiary remedy it can only be used if the formula of § 2–708(1) fails to put the seller in a similar position to that in which he would have been had the contract been performed as originally agreed.
§ 2–708. Seller’s Damages for Non-acceptance or Repudiation.
(2) If the measure of damages provided in subsection (1) is inadequate to put the seller in as good a position as performance would have done then the measure of damages is the profit (including reasonable overhead) which the seller would have made from full performance by the buyer, together with any incidental damages provided in this Article (Section 2–710), due allowance for costs reasonably incurred and due credit for payments or proceeds of resale.4
The consequences of this rule for the recovery of damages for lost profits as a loss volume seller will be discussed in a later section. Finally, under certain circumstances § 2–709 grants the seller payment of the full contractual price.
§ 2–709. Action for the Price.
(1) When the buyer fails to pay the price as it becomes due the seller may recover, together with any incidental damages under the next section, the price
(a) of goods accepted or of conforming goods lost or damaged within a commercially reasonable time after risk of their loss has passed to the buyer; and
(b) of goods identified to the contract if the seller is unable after reasonable effort to resell them at a reasonable price or the circumstances reasonably indicate that such effort will be unavailing.5
Depending on the remedy chosen by the seller and the circumstances of each case of non-performance, the measurement of damages based on the previous formulas may be substantially different. It should also be pointed out that the remedies provided to the seller in the previous rules are also granted in a parallel, yet not symmetrical, way to aggrieved buyers as follows:
§ 2–712. “Cover”; Buyer’s Procurement of Substitute Goods.
(1) After a breach within the preceding section the buyer may “cover” by making in good faith and without unreasonable delay any reasonable purchase of or contract to purchase goods in substitution for those due from the seller.
(2) The buyer may recover from the seller as damages the difference between the cost of cover and the contract price together with any incidental or consequential damages as hereinafter defined (Section 2–715), but less expenses saved in consequence of the seller’s breach.
(3) Failure of the buyer to effect cover within this section does not bar him from any other remedy.6
§ 2–713. Buyer’s Damages for Non-Delivery or Repudiation.
(1) Subject to the provisions of this Article with respect to proof of market price (Section 2–723), the measure of damages for non-delivery or repudiation by the seller is the difference between the market price at the time when the buyer learned of the breach and the contract price together with any incidental and consequential damages provided in this Article (Section 2–715), but less expenses saved in consequence of the seller’s breach.
(2) Market price is to be determined as of the place for tender or, in cases of rejection after arrival or revocation of acceptance, as of the place of arrival.7
§ 2–714. Buyer’s Damages for Breach in Regard to Accepted Goods.
(1) Where the buyer has accepted goods and given notification (subsection (3) of Section 2–607) he may recover as damages for any non-conformity of tender the loss resulting in the ordinary course of events from the seller’s breach as determined in any manner which is reasonable.
(2) The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount.
(3) In a proper case any incidental and consequential damages under the next section may also be recovered.8
§ 2–716. Buyer’s Right to Specific Performance or Replevin.
(1) Specific performance may be decreed where the goods are unique or in other proper circumstances.
(2) The decree for specific performance may include such terms and conditions as to payment of the price, damages, or other relief as the court may deem just.9
Apart from the remedies previously described, buyers also have the right to recover losses caused by defects in the quality of the purchased goods. Obviously, this remedy is available only after the seller has delivered the goods or provided the services to the buyer and, as will be discussed shortly, features idiosyncratic pleading and proof. Similarly, damages recovered because of it may be higher than those recovered from a failure to deliver the purchased goods.
The remedy for breach of warranty has a discernible component from the Anglo American law of torts, a branch of the law referred to in Spanish and Latin American jurisdictions as of “extra-contractual” or civil “delictual” liability (responsabilidad extra-contractual o por delito civil). Thus, it is not unusual under United States law that a victim from the breach of an express or implied warranty is granted damages that result both directly from the breach and indirectly from it as incidental or consequential damages.
The Official Comment 1 to § 2–313 provides a description of both types of warranties:
1. “Express” warranties rest on “dickered” aspects of the individual bargain, and go so clearly to the essence of that bargain that words of disclaimer in a form are repugnant to the basic dickered terms. “Implied” warranties rest so clearly on a common factual situation or set of conditions that no particular language or action is necessary to evidence them and they will arise in such a situation unless unmistakably negated.10
An express warranty does not require special or customary wording or language such as “this description of the product is an express warranty of its characteristics or purpose.” According to the Official Comments 5 and 6 of U.C.C. § 2–313, catalogues or publications given to the buyer, containing technical specifications, blueprints, samples or models of the sold good, may be considered express warranties.11
There are two types of implied warranties in the U.C.C.: merchantability and fitness for a particular purpose.
§ 2–314. Implied Warranty: Merchantability; Usage of Trade.
(1) Unless excluded or modified (Section 2–316), a warranty that the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant with respect to goods of that kind. Under this section the serving 1220for value of food or drink to be consumed either on the premises or elsewhere is a sale.
(2) Goods to be merchantable must be at least such as
(a) pass without objection in the trade under the contract description; and
(b) in the case of fungible goods, are of fair average quality within the description; and
(c) are fit for the ordinary purposes for which such goods are used; and
(d) run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and
(e) are adequately contained, packaged, and labeled as the agreement may require; and
(f) conform to the promise or affirmations of fact made on the container or label if any.
(3) Unless excluded or modified (Section 2–316) other implied warranties may arise from course of dealing or usage of trade.12
§ 2–315. Implied Warranty: Fitness for Particular Purpose.
Where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller’s skill or judgment to select or furnish suitable goods, there is unless excluded or modified under the next section an implied warranty that the goods shall be fit for such purpose.13
To summarize the main features of the aforementioned U.C.C. warranties, let us assume that I purchase a vehicle at a price paid in the market for similar vehicles and the vehicle does not do what similar vehicles do, i.e. transport me from A to B. I do not have to worry about proving to the court that the defendant-seller promised that the vehicle would provide me with transportation from A to B. All I have to allege is the breach of the implied warranty of merchantability. On the other hand, if I told the seller that I was going to participate in a car race and wanted to buy a vehicle that would enable me to compete in it and the vehicle I bought transported me from A to B but lacked the speed with which to compete in that race I could claim damages for the breach of the implied warranty of fitness for the specific purpose made known to the seller.
The recovery of damages resulting from the breach of these warranties has different legal grounds from that of breach of contract before performance is due. According to the Official Comment 13 of § 2–314:
In an action based on breach of warranty, it is of course necessary to show not only the existence of the warranty but the fact that the warranty was broken and that the breach of the warranty was the proximate cause of the loss sustained. In such an action an affirmative showing by the seller that the loss resulted from some action or event following his own delivery of the goods can 1221operate as a defense. Equally, evidence indicating that the seller exercised care in the manufacture, processing or selection of the goods is relevant to the issue of whether the warranty was in fact broken. Action by the buyer following an examination of the goods which ought to have indicated the defect complained of can be shown as matter bearing on whether the breach itself was the cause of the injury.14
Damages are measured using the criterion of what was objectively or reasonably foreseeable. Therefore, the defendant would be liable for all damages regardless of any amount previously recovered, if those damages were reasonably contemplated or foreseen by the parties as the probable result if the contract were breached. This criterion of what is foreseeable can be traced to the English decision in Hadley v. Baxendale, a rule still in force in common law jurisdictions.15
Independent actions for breach of express or implied warranties which are resolved on a case-by-case basis result from the diverse background of causes of action in common law contracts. Sir Roy Goode concisely and clearly restates the evolution of the remedial law of sales in common law.16
As will be recalled, in the historical description provided by Professor Farnsworth, common law as well as Roman law were in principle hostile to providing for an action for breach of executed performances without the quid pro quo. The Common law required that either the seller deliver the goods and the buyer failed to pay for them or that the buyer pay their price and receive nothing in order to grant an action for “debt”. The absence of actions for failure to perform executory promises is explained by the fact that Medieval England was primarily agricultural. Thus, its common law did not focus on commercial sales or on sales of movable property to be paid or delivered in the future except to the extent that these things had been given to the indebted defendant.
Most of the claims for breach of commercial sales were pleaded before merchant courts referred to as Court of Piepowders or before criminal courts. The former applied rules based on commercial customs, and the latter relied on rules designed to punish those who tampered with products such as beer or wine or who used false weights and measures. With the exception of the sale of edibles and beverages by suppliers, sellers were not bound by implied warranties of quality and quantity. Generally, also, sellers had no obligation to disclose latent defects known to them, nor to expressly or impliedly warrant that they had transferred good title of property or possession of the sold goods. This absence of implied warranties was part of a legal system governed by the principle of “caveat emptor” or “caveat emptoris” (let the buyer beware).17 The following phrase, cited by Goode, illustrates the harshness of the regime: “The buyer had eyes; let him use them, or suffer the consequences.”18
The remedial result was that, with very few exceptions, only expressed contractual warranties supported causes of action based on the tort of deception. This action would only stand if the plaintiff proved that the seller had knowingly made a false affirmation with respect to the nature, quality or title of the goods or services. However, if the affirmation could be tied to an express warranty of truthfulness, the buyer could file a claim of tort of deception without having to prove that the seller acted fraudulently or knowingly.
Even though common law courts in the XVI Century began to allow claims for breach of contractual undertakings not based on claims in tort but in assumpsit, it was not until 1778 that a court finally held that a claim for breach of a contractual warranty had to be filed in assumpsit.19 From there, it was only a short step to holding that claims could be brought for “implied” warranties. Nevertheless, as Goode points out, the path taken for implied warranties was unnecessarily long and tortuous, largely because of the influence of real property law, its closeness to the principle of caveat emptor and because it was apparently easier to verify if the purchased land was productive or inhabitable.
Almost a century after the 1778 decision, Jones v. Just an 1868 decision, held that implied warranties in sales of goods existed where the buyer had not been able to inspect them.20 If the buyer had inspected them, the seller was not liable for the defects even if these were latent or hidden. It was not until the end of the XIX Century that an action for breach of implied warranties was granted: 1) where the buyer had relied on the description of the goods provided by the seller, and 2) in the purchase of goods said to be fit for a particular purpose known to the seller, and in which the buyer had relied on the seller’s skills and judgment to manufacture them. The judicial grant of an implied warranty against replevin or deprivation of the buyer’s title did not take place until an 1864 decision.21
This brief historical excursus shows that, from its inception, the U.C.C. protected the commercial buyer in a broader fashion than that of the nineteenth and early twentieth century English common law. Interestingly, the broader protection of the U.C.C. started with upgrading the binding effect of the seller’s description of goods in his oral or written presentation of his products. As was previously mentioned, under the U.C.C., descriptions of goods even when only included in catalogues or blueprints became express warranties, which the buyers could not waive even if the waiver appeared in an express clause.
Secondly, the U.C.C. eliminated the link between the inspection of the goods and the seller’s liability for breach of implied warranties of the inspected goods. Regardless of inspection, implied warranties could be claimed by the buyers. Exclusion of these implied warranties under the U.C.C. is only effective if the seller expressly and clearly stipulates in the contract that they are excluded.
Under Anglo-American law, buyers of goods of lesser quality or quantity than those agreed upon, including those defectively manufactured, also have the right to claim damages for breach of implied warranties in actions that are largely predicated 1223upon the law of negligence. It is worth noting that the same legislative trend can be found in an increasing number of civil law countries.22 Under Anglo-American law, a claim for breach of an implied warranty is allowed despite the lack of privity of contract (or absence of a direct contractual relationship) between plaintiff and defendant. Therefore, an airplane manufacturer or its main distributor may be sued for breach of warranty of merchantability by a user-buyer of the airplane that has been affected by a mechanical flaw, even though the buyer did not purchase the airplane from the manufacturer or its main distributor, but from a subsequent purchaser-user.23
KRUPANSKY, Circuit Judge. In this appeal the defendant-appellant Chris-Craft Industries (Chris-Craft) has challenged the district court’s refusal to award Chris-Craft consequential damages which assertedly resulted from plaintiff-appellee’s negligence and breach of express and implied warranties of merchantability….
…
Sometime in mid-1970, Chris-Craft decided to produce a pleasure boat called MXA-25. As conceived, the MXA-25 design … [had] the fuel tank located at the stern of the craft…. Chris-Craft began production of a prototype MXA-25.
Chris-Craft had submitted a blueprint design for the MXA-25 fuel tank to Taylor & Gaskin…. Chris-Craft … discussed with Taylor & Gaskin the feasibility of utilizing a less expensive “slush compound tank” …. Although Chris-Craft had used painted tanks on its diesel boats, it had never used them on gasoline engine powered boats such as the MXA-25. Further, Taylor & Gaskin had no previous experience with the then-new slush compound method of construction. Accordingly, the trial court found that Chris-Craft and Taylor & Gaskin had equal degrees of expertise with respect to the design and manufacture of slush compound fuel tanks.
…
Subsequently, Taylor & Gaskin offered to produce the slush compound unit at a cost which was approximately ten dollars per unit less than the hot dipped galvanized tank. Taylor & Gaskin had also obtained B.I.A. approval of the slush compound tank, which was predicated upon assurances that the tanks would be covered with 1.5 mils of paint; the B.I.A. did not, however, perform any tests to determine the corrosion resistance of painted tanks. Taylor & Gaskin covered the tanks with one coat of red enamel paint, which did provide at least a 1.5 mil thickness.
Wilkins (Taylor & Gaskin’s contractor) knew that these fuel tanks would be exposed to the marine environment and, although he was unaware of Chris-Craft’s intentions relative to the unique placement on the MXA-25 of the tanks, he were found to have known—prior to production—that the tanks would be unable to resist corrosion in the marine environment and were therefore not suited for marine use. Wilkins’ own 1224estimate was that the tanks would last one year, two at the most. Nevertheless, Wilkins did not communicate this knowledge to Chris-Craft….
Chris-Craft remained unaware of the tank’s inability to withstand the marine environment when, between September 1972 and June 1973, it purchased 550 tanks from Taylor & Gaskin. Sometime in July 1973, Chris-Craft learned that the B.I.A. intended to delete the Taylor & Gaskin tank from its approved equipment list as of August 1st of that year. Upon learning of the impending change, Chris-Craft began ordering hot dipped galvanized tanks for the MXA-25. Prior notice of this change notwithstanding, Chris-Craft installed another 100 slush compound units before the B.I.A. acted to officially withdraw its approval….
In April 1974, Chris-Craft received the first of numerous customer complaints regarding corrosion of the slush compound fuel tanks on the MXA-25…. By May 1974, Chris-Craft began to suspect that the Taylor & Gaskin fuel tanks were “built in failures”. Later that month, Chris-Craft notified Taylor & Gaskin of the complaints and suggested that the two companies effect a joint recall of the slush compound tanks. Taylor & Gaskin responded that the responsibility for tank problems was on Chris-Craft and that Taylor & Gaskin would not participate in a recall effort.
…
On March 28, 1975, Chris-Craft initiated a voluntary recall campaign to replace the painted tanks with hot dipped galvanized units. Taylor & Gaskin responded to the recall by threatening Chris-Craft with a trade libel suit.
On June 3, 1975, Taylor & Gaskin initiated this diversity action to obtain $10,681.39 due and owing as payment for the slush compound tanks. Chris-Craft admitted the amount was unpaid and counterclaimed alleging negligence and breach of warranties….
Pursuant to trial, the district court found that Taylor & Gaskin had provided Chris-Craft with express and implied warranties of merchantability. However, because Chris-Craft did not rely on Taylor & Gaskin’s “expertise”, and because the two companies were found to have equal levels of expertise, the district court concluded that no warranty of fitness for a particular purpose had been made by Taylor & Gaskin.
…
The credited testimony of Chris-Craft’s expert Arthur Claess established that the tank would begin rusting at one to two months and would rust through at two years. Such evidence is sufficient to prove that the tanks were not merchantable at the time they left the control of the manufacturer, that is that they were not fit for the ordinary purpose of holding fuel in a marine environment, U.C.C. 2–314.
…
In arriving at its damage award, the trial court found that the value of the tanks at the time they left the manufacturer was zero; accordingly, Chris-Craft was awarded the contract price of the tanks, $25,114.58, offset by the stipulated unpaid amount, $10,683.19, for an ultimate award of $14,431.39 on the breach of warranties claim. Taylor & Gaskin has not appealed this judgment.
Chris-Craft’s counterclaim had included a claim for consequential damages which represented the costs of the campaign to recall and replace the defective fuel tanks. The trial court held that this was not the proper case for the award of consequential damages because, (1) “Chris-Craft has failed to present any evidence that the costs of recall were within the reasonable contemplation of the parties, either by applicable industry regulations or trade practices”, (2) “Chris-Craft failed to perform corrosion tests”, (3) rusting was also attributable to installation and design, (4) “the evidence does not establish that removal and replacement of all 550 tanks was ‘proximately caused’ by Taylor & Gaskin’s breach”, and (5) because “it cannot fairly be said that a reasonable person would have contemplated at the time of contracting that the entire result of a recall campaign would ultimately be borne by the manufacturer”. Chris-Craft has appealed this resolution of its claim for consequential damages.
…
This action was initiated to recover on a contract for the sale of goods, to a buyer for resale and damages thereunder must therefore be resolved within the dictates of the Uniform Commercial Code…. The damages which are available to the buyer as compensation for the seller’s breach under Michigan’s Uniform Commercial Code “are intended to place the injured party in as good a position as he would have been in had the promised performance been rendered”.
…
The pertinent text of 2–714 reads thus:
(2) The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount.
(3) In a proper case any incidental and consequential damages under the next section may also be recovered.
Section 2–715. Mich.Comp.Laws 440.2715, in its relevant portion, states:
(2) Consequential damages resulting from the seller’s breach include:
(a) any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise;
While the U.C.C. does not define or explicate the section 2–714 phrase “in a proper case”, it is well-settled that consequential damages for the breach of warranties are available where such damages occur. That is to say, a proper case for the award of consequential damages is a case in which damages satisfy the requisites of section 2–715(2). The Michigan state courts have consistently applied this principle to cases arising under the Uniform Commercial Code as adopted by the state…. The facts of Ambassador Steel Co. v. Ewald Steel Co., 33 Mich. App. 495, 190 N.W.2d 275 (1971), are similar to those of the case at bar. Therein, the appeals court allowed consequential damages which had resulted from the seller’s breach of warranties of merchantability with respect to steel sold to the buyer for subsequent resale. The state appellate court explained (citations deleted):
In the instant case, after the defect in the steel was discovered, the railroad cars [in which the steel had been incorporated by the defendant buyer’s customer] had to be recalled, stripped and refabricated. Defendant was charged for these operations by his customer. There is scant authority to support a contention that defendant should not be reimbursed by plaintiff for these charges. Indeed, defendant must recover these charges against him if he is to be put in as good a position as he would have been if the steel had been of commercial quality. If the steel had been of commercial quality in the first place, defendant would not have suffered these charges.
…
The rule which has thus emerged from the state court analyses of sections 2–714(3) and 2–715(2) is that consequential damages which result from the seller’s breach of warranties are recoverable to the extent that the seller had reason to know such damages would follow a breach….
…
Consistent with the foregoing, this court finds that the district court erred as a matter of law when it found that Taylor & Gaskin completely breached its express and implied warranties of merchantability, but denied Chris-Craft its consequential damages.
How does the amount of damages that could possibly be recovered under U.C.C. section 2–714 compare with those damages that could possibly be recovered from a substitute sale or purchase?
§ 2–714:
(2) The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount.
(3) In a proper case any incidental and consequential damages under the next section may also be recovered.25
How do these elements differ from those which the plaintiff would have had to claim and prove if Taylor & Gaskin had not delivered the promised goods in due time? How would this case have been decided if, instead of applying the U.C.C. provisions, the court applied the English case law described by Professor Goode and applied until the late XIX Century? Why did the defendant not try to prove that Chris-Craft had examined the tanks at the time of delivery? If both parties had technical expertise on fuel tanks in a marine environment, why is it that both the trial court and the court of appeals determined that the manufacturer had breached the warranty of merchantability? On the other hand, why is it that both courts dismissed the claim for breach of the warranty of fitness for a particular purpose? It must be noted that in the decision at hand the losses suffered by the plaintiff were considered as foreseeable by the parties. Nevertheless, in the previous section we made reference to the rule in 1227Hadley v. Baxandale in which foreseeability is required on behalf of the defendant, seller or manufacturer. What are the consequences of this distinction? Which criterion would the reader prefer as attorney to the plaintiff? Finally, would this type of recovery of damages be granted in your country? When answering this question, the reader must ask himself the question that Von Ihering would: What is the purpose that the law ascribes to claims for breach of implied warranties? If there is no legal concept that performs such purpose, would the reader suggest its creation?
The following comment is based on a presentation made in my comparative commercial law seminar at the Carlos III University Law School of Madrid during the spring of 2004 by Dr. Cristian Larraín (presently Professor Cristian Larrain in his native country of Chile). His topic was the comparison between the Spanish Civil and Commercial Code actions for breach of sale agreements and actions for breach of the implied warranty of merchantability under U.C.C. Article 2. What follows is a summary of Professor Larraín’s oral presentation.26
Articles 1484 and 1486 of the Spanish Civil Code set forth the remedies for the sale of goods with patent and latent defects but fall short of the U.C.C. remedies for the seller’s breach of the implied warranty of merchantability and fitness for purpose. The Spanish remedy that comes closest to the U.C.C. remedies for breach of warranty is the redhibitory action for defects in the goods sold. Normally a redhibitory defect is a latent defect, of such magnitude, that it renders the good inappropriate for its normal use or purpose, or that it so diminishes its value to the purchaser that he would have only purchased it for a much lower price.
Professor Fernando Sanchez Calero, one of Spain’s most respected commentators of the Civil Code distinguishes between a flaw and a defect. A flaw refers to the lack of certain promised or guaranteed qualities. (Thus, I would add parenthetically, that such a flaw presupposes an express warranty). In addition, the redhibitory action enabled by the flaw includes an action to reduce the price paid quanti minoris (or reduction of the price paid).27
The redhibitory action then is mostly for latent flaws and these flaws are not measured against what other merchants would have deemed a merchantable good, in their trade. Hence, the implied warranty of merchantability is a concept and a remedy foreign to the Spanish Civil Code. According to Professor Larraín, perhaps the most important difference between the U.C.C. conceptual and remedial scheme and that of the Spanish Civil Code is that in the latter, the goods uselessness is a consequence of a physical flaw or defect. If the good cannot be used by its purchaser for reasons other than a patent or latent defect but simply because it does not qualify as merchantable (say because it is obsolete by the standards of similar goods) a redhibitory action is 1228unavailable. Additionally, the Civil Code requires that the flaws or defects be latent. If they are patent or evident, the legislator assumes that the buyer knows of them and acknowledges their existence, which would probably lead only to the remedy of reduction in the price. As provided in Article 1484 of the Civil Code, the seller “won’t be liable for patent defects, or others that are not apparent, if the buyer given his occupation or profession has the necessary skills to easily identify them.”
Article 336 of the Spanish Commercial Code also provides remedies for the defects in the quality of the goods sold; however, Sánchez Calero and Larraín find its regulation imprecise. On one hand, the buyer who examines the goods upon delivery will have no right to claim against the seller for flaws or defects, and if he does not examine them, he is granted four days from the time of delivery to claim such defects. The imprecision resides in the shortness of the terms; the law could hardly be referring to latent flaws and defects. Also, releasing the seller from liability when the buyer has examined the goods upon delivery seems to be referring to flaws and defects that are evident to the eye. But if they are latent, the buyer will hardly ascertain them in four days, and even worse, upon their receipt.28
I would suggest that the reader reflect on what makes the U.C.C. breach for the implied warranty of merchantability such a foreign concept to the Spanish Civil Code.
CUDAHY, Circuit Judge
…
I.
Diasonics is a Delaware corporation engaged in the business of manufacturing and marketing medical diagnostic equipment. R.E. Davis Chemical Corporation (Davis), an Illinois business, contracted to purchase one such device, a .35 tesla nuclear magnetic resonance instrument (MRI), from Diasonics at the price of $1,500,000 pursuant to a written agreement dated February 23, 1984. By the terms of the agreement, upon payment of the full purchase price Davis was to be furnished a $225,000 research grant “based on [an] approved program of development activities.” … The agreement also afforded Davis the option to upgrade the MRI to a high field/spectroscopy system by June 1, 1985—approximately 15 months after delivery of the MRI was scheduled—at an additional cost of $700,000. Davis advanced a $300,000 deposit for the MRI but failed to take delivery, thereby breaching the contract. After Davis repudiated the contract, Diasonics resold the MRI to a third party at the contract price.
When Diasonics refused to refund the $300,000 deposit, Davis filed suit demanding return of the down payment pursuant to section 2–718(2) of the U.C.C. (1985). Diasonics counterclaimed, alleging that it was entitled to recover the profit it lost on the sale under U.C.C. 2–708(2) (1985) because it was a lost volume seller. The district court entered summary judgment for Davis, holding that lost volume sellers 1229are not eligible for recovery of lost profits but rather are limited to damages measured by the difference between the resale price and the contract price together with incidental damages under U.C.C. 2–706(1). Concluding that the Illinois Supreme Court would follow the majority of jurisdictions, which allow lost volume sellers to recoup their lost profits under U.C.C. 2–708(2), we reversed and remanded the case with instructions that
the district court calculate Diasonics’ damages under 2–708(2) if Diasonics can establish, not only that it had the capacity to make the sale to Davis as well as the sale to the resale buyer, but also that it would have been profitable for it to make both sales … [and that Diasonics] probably would have made the second sale absent the breach.
On remand, Diasonics filed a motion in limine to preclude Davis from introducing evidence of the additional expenses Diasonics would have been forced to incur had Davis performed its part of the bargain and elected to exercise the upgrade option. The district court granted this motion at the start of the three-day bench trial. Concluding that Diasonics had adequately established damages for its lost profit amounting to $453,050, the district court ultimately entered judgment for Diasonics in the sum of $153,050 ($453,050 less the $300,000 deposit which Diasonics retained).
On appeal, Davis … contends that the district court erred by refusing to allow it a $225,000 credit for the research grant and by excluding evidence of the loss Diasonics would have sustained had Davis exercised its upgrade option.
II.
Ordinarily, a seller’s damages for a buyer’s breach of contract are measured by the difference between the contract price and the market price. In some situations, however, this sum is inadequate to place the seller in as good a position as performance would have done. For example, a broken contract costs a lost volume seller—one with a finite quantity of customers and the capacity to make an additional sale—its profit on one sale. To be made whole, a lost volume seller must thus recover damages equal to the profit it lost on the sale.
In accordance with this reasoning, in Diasonics I, 826 F.2d at 681, we adopted for the first time in Illinois the rule that a lost volume seller is entitled to recoup its lost profit. We held that in order to qualify as a lost volume seller, a plaintiff must establish the following three factors:
(1) that it possessed the capacity to make an additional sale,
(2) that it would have been profitable for it to make an additional sale, and
(3) that it probably would have made an additional sale absent the buyer’s breach.
A. LOST VOLUME SELLER STATUS
Diasonics has adduced ample evidence to establish its status as a lost volume seller. The evidence is undisputed that Diasonics possessed the capacity to manufacture one more MRI. Diasonics also demonstrated that it was, in the words of Judge Kocoras, “beating the bushes for all possible sales.” … Based upon this evidence, the district court’s finding that Diasonics probably would have made an additional sale but for Davis’ breach is not clearly erroneous.
Davis offers no evidence to controvert the proof adduced by Diasonics that it both possessed the capacity to manufacture additional MRIs and was actively soliciting every possible customer for MRI sales in 1984. Instead, Davis clutches at one footnote in our previous opinion to justify its contention that Diasonics must precisely identify the resale buyer…. The mere fact that Diasonics was unable to specify the particular unit Davis contracted to buy and trace the exact resale buyer for that unit thus should not foreclose it from recovering lost profits. Without more evidence, we decline to impose upon Diasonics the burden of proving the exact buyer who purchased this particular system in order to qualify as a lost volume seller.30
Footnote 13 of Diasonics I sets forth one commentator’s three factor test for determining whether a buyer’s breach ahs resulted in loss of sales volume:
(1) the person who bought the resold entity would have been solicited by plaintiff had there been no breach and resale (in other words, if the resale buyer would have been an additional buyer itself) (Parenthesis added.)
(2) the solicitation would have been successful, and
(3) the plaintiff could have performed the additional contract.31
B. DAMAGE CALCULATIONS
…. Diasonics need only prove its damages with reasonable certainty, not with mathematical precision.Moreover, the district court’s conclusions regarding Diasonics’ computations constitute factual determinations that cannot be overturned unless clearly erroneous….
C. RESEARCH GRANT
The district court refused to deduct $225,000 from Diasonics’ damages, ruling that the conditions precedent to provision of the research grant—payment payment of the full contract price and approval of a program of development activities—had not been satisfied. Simple reliance upon Davis’ failure to comply with the conditions precedent to payment of the research grant, however, effectively skirts the true question at issue here—whether the research grant was what it purported to be or was really a discount masquerading in other garb. If the research was indeed genuine and would have redounded to Diasonics’ benefit, then Diasonics is not obliged to dole out $225,000. But if both parties understood the research grant to be a type of rebate, automatically payable upon receipt of the MRI in return for practically worthless information, then Davis should receive a $225,000 credit on the damages it must pay Diasonics. Davis’ breach does not entitle Diasonics to gain more than the benefit of its bargain. Upon remand, the district court must thus determine whether the research grant served merely as a disguised discount from the purchase price, or whether it constituted an independent exchange supported by genuine consideration.
D. UPGRADE OPTION
The last and most complex issue entails a similarly fact-intensive inquiry into whether the upgrade arrangement constitutes a true option or, rather, an integral and enforceable provision of the original contract. Illinois courts generally hesitate to 1231enforce options unless the option holder has clearly availed itself of the right by performing all conditions precedent to its exercise…. This particular care probably reflects the potential for unfairness when allowing an option holder to benefit from an agreement by which it could not have been bound. Reasoning that Davis failed to comply strictly with the condition precedent to exercise of the option by repudiating the contract, the district court accordingly excluded evidence of the losses Diasonics would allegedly have sustained had it performed the upgrade.
If the upgrade were a virtual certainty, however, the expenses of conveying a highfield/spectroscopy system that Diasonics avoided as a result of Davis’ breach should certainly figure in the lost profits damage calculus. Davis presented some evidence to suggest that the upgrade provision, though couched in option terminology, was actually an integral part of the original bargain. (As footnoted in the decision: Davis introduced evidence that it specially designed the MRI building to house the more powerful highfield/spectroscopy system. Moreover, it appears that Diasonics itself initially characterized the upgrade provision as an enforceable part of the original agreement when it counterclaimed seeking additional damages for the profits it lost by Davis’ failure to upgrade.)
Courts are often forced to divine the true meaning of such ambiguous arrangements.
…
Attempting to realize the true intentions of the parties does not require us to engage in abstract calculations of theoretical probabilities. Avoiding the thicket of academic economics, we opt for a pragmatic approach. Only when the evidence demonstrates a substantial likelihood that the option would have been exercised and persuasively establishes the value of the option should that value figure in the calculation of damages….
Without more evidence, it is impossible to determine whether Davis’ upgrade option should enter into the calculation of Diasonics’ lost profits…. Upon remand, the district court should determine the probability that the option would have been exercised by examining the following non-exhaustive set of factors:
(1) the importance of the option to the original bargain,
(2) the relationship between the option’s value and the additional $700,000 Davis was required to pay, and
(3) the relationship between the value of the MRI Davis contracted to buy and the original contract price.
If the original contract price was inflated and the additional $700,000 essentially nominal in relation to the value added to the MRI by the upgrade, then both parties may have understood that the only economically rational course available to Davis was to purchase the upgrade. Under such circumstances, Davis would probably have exercised its option. But if the additional $700,000 even roughly approximated the value added to the MRI by the upgrade, Davis may well have chosen not to exercise the option.
III.
Diasonics is entitled to the benefit of its bargain, no more, no less. Although we hesitate to burden district courts with impossibly complex damage computations, we remand for further consideration of the evidence with respect to the research grant and the upgrade option. The district court’s entry of judgment is thus AFFIRMED IN PART, REVERSED IN PART, and REMANDED for further proceedings not inconsistent with this opinion.32
The loss of profits to a seller who claims damages because of the loss of volume of sales caused by the buyer’s failure to buy the goods he promised when he was supposed to has caught the attention of scholars interested in an “Economic Analysis of Law” (hereafter abbreviated as EAL). This analysis has become quite popular among legal theorists in the United States, Europe and Japan and is beginning to spread to Spanish-America. As noted by Professor David Ramos from the University Carlos III de Madrid:33
One of the most influential lines of thought in contemporary legal writings, especially where private law is concerned, is the EAL. One of its seminal writings was Professor Ronald Coase’s article The Problem of Social Cost.34 In his article, Professor Coase applies his theory on the costs of market transactions to the analysis of legal phenomena … Whether one agrees or not with this type of argument, the truth is that there are some areas of law where it is impossible to understand the consequences of certain rules or points of view without taking into account the economic considerations set forth by the EAL. Such is the case of the law of contracts and, more precisely, the issue at hand: what should be the recovery of lost profits for a lost volume seller.
The following extended comment expresses my views on EAL not merely as a body of knowledge that can help discern the economic consequences of the statutory and decisional law that governs commercial contracts but also as a method for prescribing better, or in the language of EAL, “more efficient” commercial contract law rules. For this reason the following section is written a propos of the issues raised by the damages for lost volume, i.e., using the discussion of these damages as a springboard for the wider consideration of the province and function of EAL. Having this dual purpose in mind, it will be necessary to delve, albeit elementarily and summarily, on the main analytical tools (principles, corollaries and concepts) relied upon by EAL.
As described by Judge Richard Posner, the most influential of EAL writers:
… [E]conomics is the science of rational choice in a world—our world—in which resources are limited in relation to human wants. The task of economics, so defined, is to explore the implications of assuming that man is a rational maximizer of his ends in life, his satisfactions—what we shall call his “self interest.”35
Central to Judge Posner’s EAL, then, is the assumption that man is a rational self-interest (or utility) maximizer in all areas of life, not just in his economic affairs. This assumption implies that people respond to incentives—“that if a person’s surroundings change in such a way that he could increase his satisfaction by altering his behavior, he will do so.”36 From this utilitarian proposition he derives three fundamental principles of economics. The first is the law of demand, which poses an “… inverse relation between price charged and quantity demanded…. If the price of … [a commodity] rises [significantly]…. [b]eing rational and self-interested, the consumer will react by investigating the possibility of substituting goods that he preferred less….”37 The relative or alternative relationship between lowest prices charged by sellers and their costs of opportunity.
This relationship is relative (my term) or alternative (his) because the “lowest price that a rational self-interested seller would charge…. is the price that the resources consumed in making (and selling) the seller’s product would command in their next best use—the alternative price.”38 Put more simply, if I am to manufacture X, which requires a capital input of Y and a labor input of Z, the price I pay for these inputs must exceed that which would have been paid by another bidder for the same inputs, otherwise they would have been sold to that bidder and not to me.
As apparent from this illustration, the economic concept of cost is more inclusive and subtle than the mere addition of the prices of all the resources consumed by the seller. Hence, Posner refers to the cost of opportunity as “the second fundamental principle of economics” because of its corollary notion that a cost is incurred whenever someone, in what he refers to as the world of economic affairs, is denied the use of that resource.
Since I can breathe as much air as I want without depriving anyone of any of the air he wants, no one will pay me to relinquish my air to him; therefore air is costless [although this is not to say that clean air is costless]…. [Thus] the principal cost of higher education is not tuition; it is the foregone earnings 1234that the student would have if he were working rather than attending school.39
As part of the economic measurement of costs, Posner adds a “slightly oversimplified” version of Professor Coase’s theorem: if, as with the breathing of unclean air, the transactions are costless, the initial use to which property is put by its owner or possessor (Posner refers to this use as its initial assignment) will not affect the ultimate use of the property. He gives the example of the farmer entitled to compensation for the destruction of his crops by sparks from the adjacent railroad.
Assume that his [the farmer’s] crops are worth $100 and are flammable, that the value to the railroad of unimpeded use of its right-of-way is $120, but that at the cost of $110 the railroad can install spark arresters that will eliminate the fire hazard. On these assumptions, the real value of the crops to the farmer is not $100 but somewhere between $100 and $110, since at any price above $110 the railroad would install spark arresters rather than buy the farmer’s property right, but that at any proice below $110 the railroad would buy the property. The farmer is better off selling his property to the railroad at a price between $100 and $110; he will do this because the railroad will buy at aprice in that range; and as a result his land will be shifted into some fire-insensitive use, just as if the railroad had owned it in the first place.40
The conclusion Posner draws from Coase’s theorem is that the forces of competition tend to make opportunity cost the maximum as well as the minimum price of economic resources. And that a “price above the opportunity cost is a magnet drawing resources into the production of the good until, in accordance with the Law of Demand, the increase in output drives price down to cost….”41
The concept of marginal cost serves is an additional analytical tool for the measurement of costs. Posner refers to it as “the change in total costs brought about by a one-unit change in output; in other words, it is the cost that would be avoided by producing one unit less.”42 As the reader will recall, this concept was at play in the determination of the damages for lost sales in the Diasonics decision. It is also at play in the definition of price equilibrium: “a point at which, unless the conditions of demand or supply change, there is no incentive for sellers to alter the price or output.”43
Armed with the above two principles, their corollaries, a theorem and related conceptual tools, Posner explains his third principle or that of economic efficiency:
[R]esources tend to gravitate toward their most valuable uses if voluntary exchange—a market—is permitted…. By a process of voluntary exchange, resources are shifted to those uses in which the value to consumers, as measured by their willingness to pay, is highest. When resources are being 1235used where their value is highest, or, equivalently, when no reallocation would increase their value, we are saying that are being employed efficiently.44
This principle was so dear to Posner’s original pan-economic world of policy choices that at one point he advocated reliance on the price paid by the highest bidder as the most efficient (and thus socially preferable) method for allocating the adoption of abandoned children.45 Presently, Judge Posner acknowledges that the term “efficiency” to denote that allocation of resources in which value is maximized in a utilitarian Jeremy Bentham like fashion (“the greatest good for the greatest number” or the “felicific” calculus of excess of pleasure over pain) is flawed as an ethical criterion.46
… First, most people don’t believe … that maximizing happiness, or contentment, or joy, or preference satisfaction, or the excess of pleasure over pain, or some other version of utility is or should be one’s object in life….
Second, by aggregating utility across persons, utilitarianism treats people as cells in the overall social organism rather than as individuals. This is the source of a number of well-known barbarisms seemingly implied by utilitarian ethics, such as the deliberate sacrifice of innocents to maximize the total amount of happiness….47
The objections to the link between economic efficiency and utilitarianism have “turned many economists to a definition of efficiency that confines the term to outcomes of voluntary transactions.”48 Judge Posner is among them, and he places himself among the economists that have adopted the Kaldor-Hicks concept of transactional efficiency or wealth maximization. This concept takes into account the wealth maximization effects not only between the parties directly involved in the transaction but also upon third parties.49
Thus, a sale of a wood carving that A (the seller) values at $50 and B (the buyer) values at $120, if sold for a price anywhere between these two figures would yield a total benefit to the parties of $70. If the harm (if any) done to third parties (minus any benefit to them) does not exceed the $70, then taking into account the wealth maximization effects upon the contracting parties and third parties, the result would be an efficient transaction.50 He adds that “when an economist says that free trade or competition or the control of pollution or some other policy or state of the world is efficient, nine times out of ten he means Kaldor-Hicks efficient.”51
Finally, Judge Posner expresses awareness that his reader may be troubled by what appear to be severely unrealistic assumptions that underlie economic theory such as the rationality of human behavior. Yet, his version of rationality is a minimalist one: 1236“rationality is objective rather than subjective; it is the ability and inclination to use instrumental reasoning to get on in life and thus does not assume consciousness (rational decisions are often intuitive).”52
Despite the minimalism of its rationality, “the assumptions of economic theory are one-dimensional and pallid when viewed as descriptions of human behavior—especially the behavior of such unconventional economic ‘actors’ as the judge, the litigant, the parent, the rapist, and others whom one encounters in the economic analysis of law.”53 To these actors, and because our subject is the law of commercial contracts, I would add the behavior of everyday merchants as well as of the Bonus Vir. Before we examine the usefulness of EAL in the context of the law of commercial contracts it is necessary to contrast the behavior of Posner’s rational-maximization-of-wealth-person, whom we will refer to as Posner’s Homo Economicus with that of ordinary, everyday merchants and with the Bonus Vir.
Posner himself refers to the compendium of principles, corollaries and other conceptual tools that comprise the economic theory that explains the behavior of his Homo Economicus as abstract. He defends its abstraction, however, by stating that “abstraction is of the essence of scientific inquiry, and economics aspires to be scientific…. [I]ts lack of realism in the sense of descriptive completeness, far from invalidating a theory, is a precondition of theory. A theory that sought faithfully to reproduce the complexity of the empirical world in its assumptions would not be a theory—an explanation—but a description.”54
With due respect, Posner’s justification of the abstract economic theory that informs the behavior of his economic man and his rejection of the description of complexities is semantics and not science. To be sure, abstraction is a child of mathematics and especially of the mathematical ability to “simplify” or synthesize observable data by reducing it to its most comprehensive yet tersest formula possible. Yet, these mathematical formulas are as scientifically valid as the data they synthesize. As an example of an abstract yet highly useful scientific formulation, he refers to Newton’s law of falling bodies, even though this law was, according to Posner, unrealistic in its assumption that bodies fall in a vacuum and for this reason was superseded by Einstein’s general theory of relativity.55
Yet, even if Newton’s theory of what explains the falling of bodies was “unrealistic” it still illustrates the need for a precise and accurate description of the phenomena the scientist intends to explain and predict. Without it, a lay observer such as Posner may reach the conclusion that it was an unrealistic theory. In Newton’s case, his description of the phenomena he was trying to explain by mathematical laws took place in the universe of our every day life. He chose a seminal factual assumption in 1237the analogy between the falling apple and a “falling” moon and explained it by a verifiable force, the law of gravity.56
Newton’s factual assumptions work for the observable world, although not for Albert Einstein’s universe in which space and time become a continuum. Einstein’s general theory or relativity sprung from an equally seminal factual assumption-no matter how fast an object might accelerate; it will never catch up with a beam or wave of light.57 Einstein’s “realistic facts,” then, were those of a world of objects attempting to move at the speed of light, where time slows down, space stretches and gravity is the result of a space-time curvature. These facts were not those of Newton’s everyday world of falling apples and the moon being attracted by the earth’s gravity.58 Thus, both theories, in their respective contexts, were built upon equally realistic and ultimately verifiable set of seminal facts.
Significantly, the reason Einstein considered Galileo Galilei the father of modern physics was precisely because he was the first to synthesize mathematically his carefully described observations and experiments on the motion of falling bodies, and especially their acceleration.59 The importance of a valid observation and description in the formulation of a scientific theory was illustrated by Galileo’s discarding Aristotle’s unrealistic view that heavier bodies fall faster than lighter ones and that the reason why all bodies fall is because “they long to be united with earth”.60
In contrast with Galileo’s, Newton’s and Einstein’s seminal factual assumptions, Posner’s Homo Economicus is governed by principles, corollaries and concepts so broad and abstract that they predict only the most basic of commercial behavior.
Yet, will these principles, corollaries and concepts help a merchant decide whether or not to do any of, for example, the following: 1) reduce his prices significantly to a) introduce a product in the market as a “loss leader”, b) reduce the same prices to long term clients who suddenly find themselves in serious economic difficulties but who may recover and continue to buy his products at regular prices? 2) fulfill his “brotherly” duty to “pick up the bundle” of a seriously ill or deceased colleague and deliver the profits to the colleague’s family? 3) increase the salary of his employees beyond the minimum wage if his profit margins are still healthy; 4) assume a risk of loss, even though it was not brought about by his willful or negligent acts, thereby increasing the credibility of his promises and trust among fellow merchants and customers? Or would they help a legislator allocate a risk such as described in 4) among various non culpable parties?
I doubt that Posner’s economic analysis will answer these questions with a modicum of accuracy. The reason is because the behavior he ascribes to the rational 1238man is often at odds with the behavior of an archetypal merchant. Recall his failure to take into account the appraisal practices of commercial real estate brokers’ in the J. C. Penney case. Recall also his agreement with Justice Holmes’ (and Thomas Hobbes’) archetypal “bad man’s” entitlement to breach his contracts as long as he is willing to pay the damages. Note also that his rational man’s decisions are snapshots of individual transactions and seldom take into account the merchants’ concerns with the streams of related, including future, transactions between the same and third parties. Finally, notice the lesser role he attributes to the presumed contractual good faith (honesty, reasonableness and fairness of the archetypal merchant) while he is willing to rely on a conjectural subjective state of mind of the defendant in the J.C. Penney decision, a conjecture based upon “bad man” inspired assumptions of his contractual behavior.
In 1985, the so called Articles 3–4–8 Committee appointed by the Permanent Editorial Board of the U.C.C. completed a third draft of the proposed Uniform New Payment Code. Its purpose was to replace many of the provisions that dealt with the transfer of funds whether by electronic or paper based means, including negotiable instruments and some investment securities. It contained two major changes in the allocation of losses caused by the forgery of the drawer’s signature and of subsequent endorsements. Of these, only the former allocation will be discussed, especially because EAL influenced its justification.61
Section 204 of the proposed New Payment Code (NPC) dealt with allocation of loss among the payor bank, collecting banks, presenting banks and other prior transferors of checks and drafts deposited with collecting banks and forwarded “downstream” toward the payor-drawee banks or banks where the drawer of the check or draft had a deposit and checking account. Under the pre-existing § 3–418 the U.C.C. rule, inspired by Lord Mansfield’s landmark 1762 decision in Price v. Neal,62 payment of an item63 is final if the party presenting it to the payor bank is a holder in due course or is someone who in good faith relies on the finality of that payment.64
The drawee bank, which pays on an item with a forged signature, also had the duty under U.C.C. Article 4 to re-credit the innocent customer’s account because such a payment was deemed as unauthorized by its drawer and thus “improperly” payable.65 As pointed out by Professors Steven B. Dow and Nan S. Ellis, the payor bank may assert defenses in response to its customer’s demand for re-credit, such as preclusion by having acted negligently in facilitating the forgery or by failure to promptly report 1239the forgery after reviewing the item.66 However, even if the payor bank can prove the customer’s negligence, the bank’s own negligence may disqualify its defense of contributory or comparative negligence.67 Thus, the combination of Price v. Neal (as adopted by U.C.C. § 3–418) and U.C.C. § 4–401(1) resulted in a powerful protection of both customers whose signatures were forged in checks that they had not issued and of equally innocent third parties who in good faith gave value on these instruments by discounting or negotiating them. It was the protection of the latter which had prompted Lord Mansfield to analogize the discounted or negotiated drafts to money.68
The drafters of the NPC justified the removal of the protection of holders in due course of instruments with forged signatures with, among others, factual or transactional and an EAL inspired arguments. They rejected the traditional justification for the rule of Price v. Neal that asserted that the payor bank was in a better position to detect the forgery of its own customer’s signature because it was inconsistent with modern banking practices in which a large number of items are processed by computers. The second argument against the two hundred year old rule was it was impractical and uneconomic. The impracticality and economically inefficient nature of the rule was reflected by the alleged reality that banks do not check signatures under a certain dollar amount even though they will be liable on them.69
This argument seems inspired by the principle of cost opportunity and its corollary notion that a cost is incurred whenever someone, in what Judge Posner referred to as the world of economic affairs, is denied the use of that resource as well. It is also influenced by the concept of marginal cost. In other words, if the bank’s resources are more productive and capable of being maximized by not checking for the forgery of signatures for amounts below a certain figure, why continue to insist on a rule that will only be ignored by the banks in favor of a more “efficient” allocation of their resources? Why not exempt them from the liability for an undiscovered forgery and allow them to maximize their wealth more efficiently? How such a reasoning would satisfy the Kaldor-Hicks requirement of taking into account the third party’s (i.e. holder in due course’s) wealth maximization was left unanswered. Similarly, the consequences of a marginal cost analysis did not seem to be taken into account.
As pointed out by Professors Dow and Ellis,
Implicit in these statements is the idea that at some dollar amount [for each item], it would be economical for the payor bank to verify its customer’s signature given the costs of verification and the certainty and extent of liability.70
Thus, as pointed out by Dow and Ellis, even if what the drafters of NPC assumed as a transactional fact was true, then why not allow the rule to remain in effect for those large amount items whose cost of examination was justified by the amount of the 1240item, especially when the drafters had used the same economic cost argument to abolish the rule.71
The NPC was rejected as a whole and one of the reasons that prompted that rejection was its abolition of Price v. Neal. This was very surprising to some of the members of the Permanent Editorial Board who could not understand why a rational banker intent on maximizing his wealth and reducing his exposure to risk would not welcome a rule that eliminated such an exposure. When one of them asked me this very question, my reply was by way of another question: did you establish with the bankers what they deemed as the most rational and efficient rule to maximize their wealth when allocating the risk of forgery of their customers’ signatures?
One such a banker and lawyer in charge of his bank’s risk management department stated his bank’s reasons for rejecting the abolition of Price v. Neal as follows:
It is true that we might derive a short-term benefit from the elimination of liability vis-à-vis holders in due course. Yet, we need to weigh this apparent gain against the loss in the volume of circulation of checks and the willingness of third parties to discount or negotiate them and then bring them to us for final payment. We are happy with our volume of check circulation. In addition, we have already internalized the cost of this risk by including it in our insurance coverage for errors and omissions. By now it is a perfectly acceptable cost. Therefore, we could not see stopping a trust and business inducing practice because of an assumption by economic theorists that an exemption from liability is our most efficient way of doing business. Frankly, we believe we know our business and its efficiency better than those who fashioned the new rule.72
Clearly, the drafters of the NPC would have greatly profited from taking into account the above “best practice” considerations as expressed by everyday merchants and market participants.
In the final analysis then, the reason why the help of these principles, corollaries, theorems and concepts is in my opinion quite limited is because of what Judge Posner refers to as the “one dimensional and pallid” assumptions of economic theory and their failure to capture “the full complexity, richness, and confusion of the phenomena….”73
As became apparent in the bankers’ rejection of the NPC, this is a richness that must take into account factors such as the nature of the business and marketplace and their variants on costs and profit margins, longer-term considerations such as caused by relationships with customers, colleagues and third parties and last but not least, the reasonable expectations of bank customers.
As apparent in the discussion of the NPC’s failed abolition of Price v. Neal, EAL draftsmen’s reliance on the behavior of an archetypal economic man making short run, marginal cost and utility decisions, without more, had serious normative shortcomings. On the other hand, as shown by the research of Professors Charles Goetz and Robert Scott, among others,74 economic theory can contribute to a better adjudication of commercial contract disputes. Consider, for example, their analysis of the decision in Neri v. Retail Marine Corp.75
Retail Marine, a boat manufacturer, sold Neri a boat for the price of $12,587.40, against which they made a down payment of $4,250.00. Soon after the sale, Neri repudiated the contract. Four months later, Retail Marine sold the same boat to another buyer for the same price as previously contracted with Neri. As in Diasonics, Neri claimed the refund of his down payment of $4,250.00; Retail Marine opposed it and counterclaimed arguing that had it not been for Neri’s breach, Retail Marine would have had two separate profits, one resulting from the contract with Neri and the other from the subsequent sale of a similar boat. The Court of Appeals of the State of New York admitted the counterclaim and held that the measure of damages by calculating the difference between the market price of the boat that Neri failed to purchase and the price stipulated in the breached contract was not enough to place the seller in as good a financial position as Neri’s performance would have done. Therefore, Retail Marine had reason to claim the lost profits from Neri as a lost volume seller.76
As noted by Goetz and Scott, “[t]he court categorized Retail Marine’s situation as that of a dealer with an ‘inexhaustible’ supply of boats; consequently, the second buyer did not replace the first.”77 Because they were considered independent transactions, it follows that recovery as a lost volume seller was granted. However, the undisputed facts did not support such a conclusion: “Mere ability to supply additional volume in no way implies that such volume could have been supplied profitably.”78
From this point on, these authors analyze the restrictive effects that factors such as the market in which Retail Marine operated and the effects that the costs of inventory could have over the seller’s expected profits.79 For example, in a market with perfect competition, meaning one in which supply and demand were in balance as a result of an unlimited number of sellers and buyers with equal access to goods and prices, Retail Marine would have no control over the price of its boats. These would sell for the equilibrium price between supply and demand in the market. Its capacity of selling with profits would be limited by, among other factors, increasing production costs.80
If Marine were to operate in a market where it had power and control over its sale prices, and if the prices had to be reduced in order to keep up with competition, 1242Marine’s volume of sale would also be influenced by the price levels, because if it was not able to pay its production costs then the volume of sales would also be affected.81
Other factors could also lead to the conclusion that if there were a market to resell boats, then the re-sales in that market would not necessarily be considered “new” but rather replacement sales for those breached and therefore would not allow for recovery of damages as a lost volume seller. Thus, profits from sales in a market for new boats have different characteristics from those from sales in a market for used boats. The same would be true of a market of spare parts in contrast with a market of fully assembled goods.
In fact, the remedy for non-performance of sales of spare parts or those in process of production is commonly that of lost profits but only pertaining to the breached sale. This is so because damages for lost profits as a lost volume seller are measured by the difference between the contractual price and the price of a substitute sale and both require that the boat be manufactured and be ready to be resold. Yet, in the case of sales of spare parts or products in process of production, the producer that does not have firm purchase orders can easily decide not to continue with the production of the contracted spare parts or goods.
There are other important analytical differences caused by markets where purchases are made directly from the producer or indirectly through intermediaries, or by markets where the goods are homogenous or standard and subject to normal sale standards, as opposed to the sale of goods that are “custom made” or manufactured upon specific requirements from the buyer. Once the differences have been identified, it is the job of the analyst to determine the microeconomic consequences of breached sales and their effects on possible substitute or new sales.
As just noted, production costs have a great influence in determining a realistic measure of damages. Economic analysis takes into consideration whether the costs alleged by the seller are fixed (e.g., lease of the place where the production plant or sales offices are located) or variable (e.g., raw materials or labor invested in the production of a specific group of boats). If fixed, they would be equally divided among all of the boats produced or sold. If variable, they would be apportioned to each boat upon which these costs were invested.
The same is true with the analysis of average and marginal costs. Average costs are those which result from dividing total costs of production by the total number of produced boats. However, in order to determine possible profits of future lost sales, several analysts use the formula for the earlier described marginal costs, i.e. the cost of producing the next unit. For instance, if 10 boats are produced at a total cost of $10,000, the average cost of each boat is $1,000. However, if production of an eleventh boat results in a total cost of $11,500 (for all the boats including the one about to be produced) then the marginal cost of that one boat is $1,500 and this is the cost used by analysts to determine whether there are profits or not from the sale that immediately follows the breach.
Obviously, if the market sale price of that boat were lower than its marginal cost, then far from receiving profits from the lost sale the producer would most likely not produce that additional boat and instead avoid the losses which he could have 1243incurred. In this case, it would not be possible to claim lost profits as a lost volume seller.
Summarizing, EAL can help in perfecting or correcting the application of law of damages by identifying analytical mistakes such as made by the court in Neri: first, when it assumed that a seller like Retail Marine could have an inexhaustible supply of boats, and second, when it decided that such a possibility characterized every future sale as a new sale, hence justifying the award of damages for lost volume.
Similarly, this analysis may prevent errors in measuring damages by suggesting when to take into consideration factors that either limit or qualify the lost volume of sales in relation to types of markets, products and their costs. Diasonics illustrates how a basic economic analysis was significant to the courts determination of the lost volume of sales. It should be recalled that in this decision a list of factors suggested by Professor Harris are cited as follows:
1. the person who bought the resold entity would have been solicited by the seller to buy had there been no breach and resale [in other words, if the resale buyer would have been an additional buyer himself];
2. the solicitation would have been successful; and
3. the plaintiff could have performed the additional contract.82
Later, Robert Casey, another economic analyst, suggested a fourth factor to be added to Harris’ list:
[A] lost-volume situation exists only when the breached sale would have provided the seller with an increase in total profit [within that fiscal or calendar year].83
As shown by Goetz and Scott’s analysis of the Neri decision, the gap between the economic theory assumptions that Judge Posner himself characterizes as “one dimensional and pallid when viewed as descriptions of human behavior” and the behavior of average and exemplary merchants is one that empirical data can and must narrow. Yet, this gap is sharply apparent in Judge Posner’s own assumptions especially one related to what he refers to as the contracting parties’ opportunistic behavior and how to deal with it. According to Judge Posner:
… [I]t is not always obvious when a party is behaving opportunistically. Suppose A hires B to paint his portrait “to A’s satisfaction.” B paints a portrait that connoisseurs of portraiture admire…. A rejects the portrait and refuses to give any reason for the rejection. If the rejection is not made in good faith, A will be held to have broken the contract…. No one would voluntarily place himself at the mercy of the other party, so it is reasonable to assume that had the parties thought about the possibility of bad faith they would have forbidden it expressly.
Should the law go further, and read into the contract an implied duty of reasonableness on A’s part? It should not (and does not). The parties probably meant A to be the sole judge of the adequacy of B’s performance. The language of the contract so suggests, though not conclusively; and the suggestion is reinforced by reflecting on the incompetence of a judge or jury to determine whether A … dissatisfied with the portrait, ought to have liked it.84
Contrast this statement with that by the Roman jurist Ulpian in D.18.1.7 (Ulpian, Sabinus, book 28) discussed during the First Part of this book.
The sale of a slave “if he shall have settled his accounts to his master’s satisfaction” is conditional; now conditional sales become perfect, only when the condition is satisfied. Does the condition mentioned refer to the master’s personal satisfaction or to the satisfaction of an honorable man? If we accept the former interpretation, the sale is null as also would be the case where a man would sell, if he chose to do so, or if he promised in a stipulation, “I will give ten if I want to”; it cannot be left to the decision of a contracting party whether he is under an obligation. Accordingly, it was settled by the earlier jurists that one looks to the judgment of an honorable man and not to that of the master himself. Hence, if the accounts were acceptable, but he refused them or if he, in fact, accepted them, but pretended not to, the condition of purchase would be realized and the vendor could be sued by the action on purchase.85
While Ulpian would seem to agree with Judge Posner that it is highly unlikely that someone would contractually place himself at the mercy of the other party, his normative solution was quite different, and in my opinion wiser and perhaps even more economically efficient. Ulpian would adopt the normative solution he attributes to the earlier jurists and rely on the judgment of an honorable man (bonus vir) and not to on that of the master himself. Hence, if the accounts were acceptable to that honorable man the condition of purchase would be realized and the vendor could be sued by the action on purchase.
When relying on the judgment of an honorable man, Ulpian gained the assistance of someone of not only a superior morality to that of Posner’ homo economicus but that of a respectable and wise merchant. This archetype had likely participated in or heard about instances where one contracting party had placed himself at the mercy of another. Thus, he could more easily tell what the parties truly meant when they agreed that A should be sole judge of the adequacy of B’s performance. Did they really mean it, or were their words only “code” words for another meaning? For this was a personage familiar with the customary practices of various contracting parties, their honorability as well as their reasonableness.
Consequently, while the homo economicus often ends up being a creature of the laboratory capable of producing only highly narrow, and short lasting rules, the bonus vir, as a flesh and bones merchant is the beneficiary of commercial contract trial and error and of the well trodden contractual and remedial paths. Empirically and intuitively, the bonus vir knows what claims are regarded as fair by the regular 1245marketplace participants and that in the final analysis it is that fairness as much as his business acumen which earns him the trust of his peers, perhaps the most valuable asset in commerce. Hence, he is highly respected by his peers and is one of the most reliable sources of good commercial practices, long run rules and consequently of a sustainable substantive and remedial law.
At the same time, there is no question that the gap between economic theory and commercial contract law making should be narrowed also by having access to the compilations of the standard and best contractual practices of average merchants. As discussed in Chapter 24, the practices that attain such a status of viability earn it because of their proven cost effectiveness and fairness to market participants, whether parties to the contract or third parties. With such an assistance, the task of the legislator and judge become much easier and their norms can truly contribute to the economic development of the jurisdiction or region.
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1 U.C.C. § 2–706(1) (2011).
2 Id. § 2–708.
3 Id. § 2–708(1).
4 Id. § 2–708(2).
5 Id. § 2–709(1).
6 Id. § 2–712.
7 Id. § 2–713.
8 Id. § 2–714.
9 Id. § 2–716(1)–(2).
10 Id. § 2–313 cmt.1.
11 Id. § 2–313 cmts. 5 & 6.
12 Id. § 2–314 (2011).
13 Id. § 2–315 (2011).
14 Id. § 2–314 cmt. 13.
15 E.g., Bongam v. Action Toyota, Inc., 14 F. App’x 275, 282 (4th Cir. 2001)
16 Roy Goode, Commercial Law 187–94 (3d ed. 2004).
17 Id. at 185.
18 Id. at 184.
19 Id. at 186.
20 Id. at 187.
21 Id. at 188 n.37 and accompanying text.
22 See Alejandro Hernandez Maestroni, Part 1: Introduction: Overview of the Study Undertaken by the National Law Center for Inter-American Free Trade, 20 Ariz. J. Int’l Comp. L. 1, 14–15 (2003) (discussing briefly Chilean, Argentine, Uruguayan, and Brazilian laws).
23 See id. at 18–19 (referencing different countries’ laws in the late 20th century that established liability for all participants in the distribution of defective products).
24 Taylor & Gaskin, Inc. v. Chris-Craft Indus., 732 F.2d 1273 (6th Cir. 1984).
25 U.C.C. § 2–714(2)–(3) (2011).
26 Cristián Andrés Larrain Páez, Las Garantías Contractuales en el Derecho Español [Contractual Warranties in Spanish Law] (2004) (on file with author).
27 Fernando Sanchez Calero, Latent Defects in Commercial Sales and the Exercise of Actions that result from them, (“Los Vicios Ocultos y el Ejercicio de las Acciones que de ellos derivan en la Compraventa Mercantil”) (Comment to a Supreme Court decision of Dec. 2, 1954.); Commercial Law Review, Madrid, April–June 1956, No. 60, pg. 449, cited by Cristian Larraín, Contractual Warranties under Spanish Law (2004) (hereinafter Larraín, Warranties).
28 This is convincingly argued by Fernando Sánchez Calero, supra note 742, pg. 454.
29 924 F.2d 709 (7th Cir. 1991).
30 Id. at 710–12 (citations omitted).
31 Id. at 712 n.3.
32 Id. at 712–14 (citations omitted).
33 David Ramos was part of the Doctorate Course at the Universidad Carlos III de Madrid, taught by the author, May–June 2004, and provided the comments here transcribed as part of his main coursework.
34 Ronald H. Coase, The Problem of Social Cost, 3 J. L. & Econ. 1 (1960). See generally Richard Posner, Economic Analysis of the Law (8th ed. 2011) (providing a history of EAL).
35 Posner, supra note 35, at 3 (citations omitted).
36 Id. at 5.
37 Id. at 4.
38 Id. at 7.
39 Id. at 8 (citations omitted).
40 Id. at 10.
41 Id. at 10.
42 Id.
43 Id. at 10–11.
44 Id. at 13.
45 See Anthony D’Amato, Globalizing Adoption: Linking Children and Adoptive Parents, 116 Christian Century 668, 669 (1999) (on file with author), available at http://anthonydamato.law.northwestern. edu/Pages-papers/globalizing-adopt-cc.pdf.
46 Posner, supra note 35, at 16.
47 Id.
48 Id. at 17.
49 Id.
50 Id.
51 Id. at 18.
52 Id. at 20.
53 Id. at 21.
54 Id.
55 Id.
56 The following remarks on Newton and Einstein’s assumptions, paraphrase those by theoretical physicist Michio Kaku in Michio Kaku, Brilliant Minds, Galileo Galilei, Isaac Newton, Albert Einstein and Stephen Hawking (Science Channel, DVD, 2008). [hereinafter Brilliant Minds]. The late and lamented Professor William Sears of the University of Arizona Aeronautical Engineering Dept. and one of the premier aeronautical mathematicians and physicist of the Twentieth Century described Professor Kaku’s writings and television programs on leading theoretical physicists as among the most lucid and accessible to the general public.
57 Brilliant Minds, supra note 57.
58 Id.
59 Id.
60 Id.
61 See Steven B. Dow & Nan S. Ellis, The Proposed Uniform New Payments Code: Allocation of Losses Resulting from Forged Drawers’ Signatures, 22 Harv. J. on Legis. 399 (1985) (evaluating the changes to the pre-existing law allocation of the risk of loss for these signatures).
62 Price v. Neal, (1762) 97 Eng. Rep. 871 (K.B.); 3 Burr. 1354; U.C.C. § 3–418 (App’x. G 2012) which stated in relevant part: “[P]ayment or acceptance of any instrument is final in favor of a holder in due course, or a person who has in good faith changed his position in reliance on the payment.”
63 The term item is used generally in bank deposits and collection law to denote an instrument such as a draft or check deposited for collection and forwarded or presented to the payor bank for its payment.
64 U.C.C. § 3–418 (1972) and id. cmt. 1.
65 U.C.C. § 4–401(c) (2012) (stating in relevant part: “A bank may charge against the account of a customer a check that is otherwise properly payable from the account….”).
66 Dow & Ellis, supra note 62, at 409.
67 Id. at 410.
68 See Lord Mansfield’s decisions in Miller v. Race (1758) 97 Eng. Rep. 398 (K.B.); 1 Burr. 452 & Peacock v. Rhodes, (1781) 99 Eng. Rep. 402 (K.B.); 2 Doug. 633.
69 N.P.C. § 202 cmt. A, cited in Dow & Ellis, supra note 62, at 426 n.153 and accompanying text (this also references the fact that a factual assumption underlying the impractical and uneconomic nature of the rule that “banks do not check signatures under a certain amount” was unproven).
70 Id. at 246–27.
71 Id. at 427.
72 The above quoted text is the result of a conversation with the head of the risk management department of a major United States bank, during the month of April 1989 in New York City. This banker and lawyer requested that his name not be revealed.
73 Posner, supra note 35, at 21.
74 Charles J. Goetz & Robert E. Scott, Measuring Sellers’ Damages: The Lost-Profits Puzzle 31 Stan. L. Rev. 323, 331–32 (1979).
75 Id. at 331–38 (discussing Neri v. Retail Marine Corp., 30 N.Y.2d 393 (1972)).
76 Id. at 332.
77 Id.
78 Id.
79 Id. at 333.
80 Id.
81 Id. at 334.
82 See supra note 32 and accompanying text.
83 Robert M. Casey, An Economic View of the U.C.C. Seller’s Damage Measures and the Identification of the Lost-Volume Seller, 49 Alb. L. Rev. 889, 909 n.115 (1984–1985).
84 Posner, supra note 35, at 117 (Emphasis added).
85 See supra § 4:6(C).