The Case of Tango Jalousi and Standards of Fairness
I would like to discuss a Danish Supreme Court verdict which raises issues concerning the application of standards of fairness in contract law. The case is interesting also from a law and economics perspective in that the economic analysis is useful in analyzing the (in my view faulty) premises of the Court.
The case involves the Danish composer Niels W Gade, who wrote Tango Jalousi during the period 1923-1925, and published it through his own publishing firm, although he had already licensed the rights to all of his productions to the Publishing house M. M therefore sued him for breach of contract, and in a settlement, the parties shared the future proceeds from the sale of Tango Jalousi. The publishing rights were granted to Gade’s own publishing firm; therefore when Tango Jalousi became internationally famous, M had very substantial earnings without incurring costs of publishing. After Gade’s death, his rights were endowed to a Foundation, created to finance stipends to talented young musicians.
In 1993, the Foundation wanted to void the agreement on the ground of unfairness. Unfair contract terms can be voided, wholly or in part, according to a §36 of the Danish Law of Contracts.
The Supreme Court found for the plaintiff on three grounds.
First, the Court stressed that when M were granted a share of royalties instead of damages for breach of contract, M was in effect awarded a stream of liquidated damage payments that far exceeded what conventional damages would have amounted to (i.e. according to the Court, M was essentially granted punitive damages).
Second, the court found the renegotiated contract to be unreasonable in that it departed from divisions of income rights that were common in the industry at the given time. In this regard, the court stressed that M were under no obligation to publish the music and therefore took on no risk – but stood to gain very much in case of success- under the new contract. In this respect, the Court found the contract to be unconscionable.
Third, the Court noted that the barrier for Court intervention was lowered due to the longevity of the contract in combination with supervening events, mainly the exceptional popularity of Tango Jalousi, and the unforeseeable technological development that greatly expanded the market for it.
The Supreme Court did not void the original contract but modified it such that M would no longer receive royalties; the royalties would henceforth be received by the Foundation and hence be allocated to young musicians.
I believe that this verdict can be criticized with respect to all three grounds provided by the Court.
Concerning the first, the question before the court had little to do with that of when liquidated damages should be enforced. The renegotiated contract gave M a right to a future income stream instead of compensation in the form of cash (or instead of specific performance), and it is hard to understand why the fact that this mode of payment resembles a stream of liquidated damage payments renders it objectionable. There are two reasons for subjecting liquidated damages to scrutiny. Either it can be feared that the breaching party overlooked the term, or the term may appear unfair in itself. The former rationale does not apply to the new contract, since the sharing of future income formed the core of the newly negotiated contract (and Gade was an experienced businessman). And the latter rationale raises the issue whether the newly negotiated contract was unfair or not, which falls under the Court’s second ground for modification.
To sum up concerning the first ground, it is not relevant that the parties agreed on a stream of payments that resembles a stream of damage payments, what matters is whether the ex-ante value of the contract, the net present ( risk-adjusted) value can be deemed unconscionable.
As its second ground for modifying the contract, the Court did indeed, as mentioned, view the contract following breach to be unconscionable. It stressed that M received rights to income stemming from radio broadcasts, an income that would, according to the Court, conventionally be allocated to the composer, and the Court further noted that M did not bear any risk, since M was neither required to publish nor to promote Tango Jalousi. However, while it may be true that M received a share not normally received in the industry, this was a consequence of the original contract going back to 1923, in which M compensated Gade by a lump sum payment. The presumption must be that the share given to M was determined by this payment from M to Gade, and there is no evidence presented to the Court that M’s share was out of proportion to this payment. Indeed the opposite is the case, as testimony during trial revealed that in 1936, during a legal battle between another Publishing house, W, and M, M offered to sell the rights to Tango Jalousi to W, at a price of 1500 Danish kroner (the offer was rejected). Thus, the Court had evidence to suggest that the net present value of M’s rights was not unconscionable, as 1500 kr was not disproportional compared to the prices at which similar rights were traded (there is reporting of such prices in the description of the case).
Moreover, it is a false premise of the Court verdict that M did not bear any risk. M ran the risk that Tango Jalousi would not become popular and that the claim on its future income stream would become valueless. M could have demanded compensation for breach of contract, either specific performance or some measure of damages; indeed, if the Court had assessed reliance damages, it could have granted M at least the repayment of the lump sum. Gade preferred to pay M a share of future income, and M was prepared to take the risk that Tango Jalousi would not become a success.
In summary, the Court failed to adequately identify the contract after renegotiation as (probably) a reasonable contract under the circumstances, partly perhaps because the Court did not distinguish sufficiently between the net present value of the claim and its ex post value.
On the third ground for modification, supervening events, it is clear that courts can make contracting easier for parties by intervening under unforeseen circumstances, but also that intervention can lower the value of contracting if carried too far, by creating uncertainty. On the positive side, a case can perhaps be made for modifying the contract on welfare grounds, if it can be argued that the optimal, complete contract between the parties would have limited M’s potential earnings. It is, however, not clear why the parties would cut off M’s earnings in case of exceptional earnings. On the negative side, the contract involved a sharing of risk in the same way as venture capital contracts do, and it can create uncertainty and little if any benefit if courts take upon themselves the role of censoring such contracts. The question is whether a venture capitalist, who gains a large share of the income of a company (perhaps larger than what is standard in the industry) may fear that if the company becomes very successful, the contract may be rescinded or modified. The answer is probably no, since the Court states that the verdict should not be understood to apply in situations where the parties have traded the risk. But then the third ground for modification cannot be seen to stand, as certainly the parties traded the risk.
Overall, the case may be unique and so its precedent may be limited. But by following the temptation to create what the judges apparently saw as the fair outcome, they may have added noise to the rules of contract validation and modification. Although standards of fairness can be an important tool for the court to reach the right (and the efficient) result, it may be worthwhile investigating whether the use of fairness standards in contract law needs to be constrained in some way.
Tuesday, March 24, 2009
Wednesday, March 4, 2009
Nuno Garoupa on the difference between US and European law schools
There are many differences between American and European law schools. In fact, so many people have written about this topic that there is hardly one difference that has not been identified by now. Having worked on both sides of the Atlantic, the main difference that never ceases to amaze me is how American elite law schools have been transformed into a micro-universe of social sciences. Most of my colleagues are economists, sociologists, philosophers, historians, psychologists, political scientists, anthropologists. Naturally this has significant implications for the type of research we do in the law school (where doctrinal work is less and less popular), for the type of professional norms we develop in the law school (with most faculty in residence throughout the day), and even for how the law is taught to students. Such environment cannot be reproduced in Europe (with some minor innovative projects here and there) because diversity and interdisciplinary dialogue are not appreciated. There are plenty of more or less sophisticated arguments in Europe to oppose such move. However, the obvious consequence is that European law schools cannot provide the intellectually stimulating environment that one finds in elite law schools in America. It is of no surprise that SJD degrees are now massively populated by Europeans who use that as an entry door into the job market of American law schools (something the Israelis have been doing for more than a decade). It is also of no surprise that Latin Americans and Asians now look to the elite law schools in America as the leading legal teaching and research institutions. The exponential increase of LLMs and SJDs from these areas of the world in the top American law schools is amazing. Unfortunately, most European law schools have been unable to react to change and competition. In many case they lack the resources, in most cases they lack the will.
Monday, March 2, 2009
Guest posting by Prof. Endre Stavang
Free allocation and the rationale for emission trading: Is there an inconsistency?
Endre Stavang, Oslo University, Faculty of Law
In this post, I argue that free allocation is not inconsistent with the basic social rationale behind alienable emission allowances, and I indicate the legal relevance of this consistency analysis to the issue of designing a robust system. My question is: Is the argument below obvious, obviously wrong, or neither?
Should allowances allocated to each firm owning a polluting plant be given with or without financial compensation? The legislator must choose: 1. Quotas are allocated to firms without financial compensation. 2. The payment of a certain amount of money determined by the state is a condition for the allocation of quotas to the firm (through the use of an auction mechanism or by other means). Existing systems are predominately based on principle 1. Is this inconsistent with the basic purpose of minimizing total costs of regulating the emissions? The answer to this question of consistency is important for two reasons. First, consistency is a basic legal value. If free allocation is not consistent with a statutory rationale that is subject to a broad consensus, it is likely not sustainable. Second, the allocation of emission allowances may be reviewed based on state aid rules. The checking of consistency between the rationale of the regulation and its various details may be a crucial element in the review under the law of state aid. In sum, the following question is of particular interest: Is it inconsistent with the main rationale behind alienable allowances to give out such allowances without compensation?
As a starting point in this evaluation, the concept of opportunity costs is relevant. Generally speaking, there will be an incentive for firms to abate under both principles. If a firm chooses not to abate, it will incur a cost in the form of lost revenues from selling allowances. The opportunity cost is as real as the expense under auctions and other forms of making firms compensate for allocated allowances. However, the existing tax system influences work incentives and savings decisions in an undesirable way. If the allowances were auctioned, the government could lower these disincentives while maintaining their total income. Thus, although the basic rationale behind alienable allowances does not dictate auctions rather than free allocation, it is clear than free allocation causes some extra social costs. By how much is an empirical question. The question, then, is whether these costs are unnecessary or whether there are some corresponding benefits of free allocation.
The benefits of free allocation are related to its distributional consequences which may feed back into the efficiency analysis for both fairness as well as public choice reasons. First, let’s look at the fairness aspect. Obviously, auctioning the allowance will, when compared to the free allocation of allowances, change the distribution of wealth between the firms and the state. If the allowances were sold by the state in a well-functioning market, the firms would have to pay a price that reflected the scarcity of the allowances, and this price would equal the tax rate that the state would have imposed in an optimal emission tax system. Thus, in addition to the costs of abatement, the firms would have to pay a tax that is disproportionate with the harm that, as a matter of theoretical attribution, is the result of the firm’s emission. This so-called excess burden is a well-known feature of an emission tax rate equal to the marginal costs of harm caused by the emission, and auctioning allowances would entail a similar excess burden. This lack of proportionality may run against sentiments of fairness and justice, and if such sentiments are widely shared by individuals in the relevant jurisdiction, it may seem justified to count this lack of fairness or justice as a cost of the auctioning system as compared with free allocation. Second, it may also be relevant under the criterion of cost-effectiveness that the design and operation of the tradable emission allowance system requires industry participation and cooperation. If auctioning rather than free allocation is chosen, and if that choice makes firms ex ante less eager to cooperate in the practical implementation of the allowance system, it may become more difficult and hence costly to gather necessary information and to run the system. Such administrative costs are relevant under the criterion of cost-effectiveness.
It may seem that the costs of fairness and administration discussed above are somewhat fanciful, and that an analysis under the cost-effectiveness criterion should only include costs that may be documented to exist. However, legislative history of the Norwegian greenhouse gas emission trading act indicates that these are real concerns. In the 1990s, some preparatory work indicated that the government was preparing for a shift towards a consistent use of “green taxes” as the preferred environmental regulatory instrument. However, after a hearing in parliament (“Stortinget”) in 1998, it became evident that the politicians and their expert advisors favoured emission allowances (property rights) over taxes to regulate greenhouse gases nationally. Moreover, in 2002, Stortinget explicitly instructed the cabinet to develop the details of the act, based on free allocations of allowances, in close dialogue with industry. In my opinion, it is reasonable to infer that the political system in this way acknowledged that there are relevant considerations to make besides the aggregate costs of harm and abatement.
Another type of argument that might be relevant and could serve as a counter-argument to the free allocation of allowances, is that such allocation contradicts the Polluter Pays Principle (PPP). This principle has been invoked by governments on numerous occasions over the years. However, the PPP comes in a narrow and a wide version. The narrow version says that the polluter should bear his own abatement costs and thus rules out the bribe option. This does not tell us anything about free allocation versus auctions, The wide version of the PPP has relevance as a theoretical idea, but is not supported by actual law or policies in any consistent way. This version states that all harm should correspond to financial expenditures for the firm. However, this version lacks support in actual legal policy-making practices. So far, a consistent set of optimal environmental taxes has not been put into effect. Industrial pollution is mainly regulated through a concession system, and the civil liability for the firms are then regulated not by pure strict liability, but through a system of tolerance limits with entails a doctrine of reasonable use. Thus, the wide version of the PPP is far removed from the preferences of the political community as revealed through actual legislation. In this situation, it is not clear why we should accord it independent weight in the evaluation under the criterion of cost-effectiveness.
It might be argued that the polluters should pay upfront for the allowances in order to keep size of the polluting sectors down. It might seem that free allocation is insufficient in this respect, since the allowances would be withdrawn if the plant shuts down. Thus, the incentive to shut down would be too small, and the polluting sectors too large. However, as long as the total emissions allowed over time are somehow kept within the fixed cap, this should not be a problem in aggregate. Moreover, a real PPP system would also be imperfect in that it is subject to the excess burden problem and thus may lead to too many shut-downs.
In sum, the conclusion must be that it is not a clear inconsistency between cost-effectiveness as the main rationale behind greenhouse gas emission trading and the choice to allocate alienable allowances without compensation. As already mentioned, this conclusion may be relevant for the application of state aid rules, and it may be that Norway and EU members have paid insufficient attention to the implications of this point in the structuring of their emission trading systems. A “property approach” to allocation plans might work, but this would have to be developed elsewhere.
Endre Stavang, Oslo University, Faculty of Law
In this post, I argue that free allocation is not inconsistent with the basic social rationale behind alienable emission allowances, and I indicate the legal relevance of this consistency analysis to the issue of designing a robust system. My question is: Is the argument below obvious, obviously wrong, or neither?
Should allowances allocated to each firm owning a polluting plant be given with or without financial compensation? The legislator must choose: 1. Quotas are allocated to firms without financial compensation. 2. The payment of a certain amount of money determined by the state is a condition for the allocation of quotas to the firm (through the use of an auction mechanism or by other means). Existing systems are predominately based on principle 1. Is this inconsistent with the basic purpose of minimizing total costs of regulating the emissions? The answer to this question of consistency is important for two reasons. First, consistency is a basic legal value. If free allocation is not consistent with a statutory rationale that is subject to a broad consensus, it is likely not sustainable. Second, the allocation of emission allowances may be reviewed based on state aid rules. The checking of consistency between the rationale of the regulation and its various details may be a crucial element in the review under the law of state aid. In sum, the following question is of particular interest: Is it inconsistent with the main rationale behind alienable allowances to give out such allowances without compensation?
As a starting point in this evaluation, the concept of opportunity costs is relevant. Generally speaking, there will be an incentive for firms to abate under both principles. If a firm chooses not to abate, it will incur a cost in the form of lost revenues from selling allowances. The opportunity cost is as real as the expense under auctions and other forms of making firms compensate for allocated allowances. However, the existing tax system influences work incentives and savings decisions in an undesirable way. If the allowances were auctioned, the government could lower these disincentives while maintaining their total income. Thus, although the basic rationale behind alienable allowances does not dictate auctions rather than free allocation, it is clear than free allocation causes some extra social costs. By how much is an empirical question. The question, then, is whether these costs are unnecessary or whether there are some corresponding benefits of free allocation.
The benefits of free allocation are related to its distributional consequences which may feed back into the efficiency analysis for both fairness as well as public choice reasons. First, let’s look at the fairness aspect. Obviously, auctioning the allowance will, when compared to the free allocation of allowances, change the distribution of wealth between the firms and the state. If the allowances were sold by the state in a well-functioning market, the firms would have to pay a price that reflected the scarcity of the allowances, and this price would equal the tax rate that the state would have imposed in an optimal emission tax system. Thus, in addition to the costs of abatement, the firms would have to pay a tax that is disproportionate with the harm that, as a matter of theoretical attribution, is the result of the firm’s emission. This so-called excess burden is a well-known feature of an emission tax rate equal to the marginal costs of harm caused by the emission, and auctioning allowances would entail a similar excess burden. This lack of proportionality may run against sentiments of fairness and justice, and if such sentiments are widely shared by individuals in the relevant jurisdiction, it may seem justified to count this lack of fairness or justice as a cost of the auctioning system as compared with free allocation. Second, it may also be relevant under the criterion of cost-effectiveness that the design and operation of the tradable emission allowance system requires industry participation and cooperation. If auctioning rather than free allocation is chosen, and if that choice makes firms ex ante less eager to cooperate in the practical implementation of the allowance system, it may become more difficult and hence costly to gather necessary information and to run the system. Such administrative costs are relevant under the criterion of cost-effectiveness.
It may seem that the costs of fairness and administration discussed above are somewhat fanciful, and that an analysis under the cost-effectiveness criterion should only include costs that may be documented to exist. However, legislative history of the Norwegian greenhouse gas emission trading act indicates that these are real concerns. In the 1990s, some preparatory work indicated that the government was preparing for a shift towards a consistent use of “green taxes” as the preferred environmental regulatory instrument. However, after a hearing in parliament (“Stortinget”) in 1998, it became evident that the politicians and their expert advisors favoured emission allowances (property rights) over taxes to regulate greenhouse gases nationally. Moreover, in 2002, Stortinget explicitly instructed the cabinet to develop the details of the act, based on free allocations of allowances, in close dialogue with industry. In my opinion, it is reasonable to infer that the political system in this way acknowledged that there are relevant considerations to make besides the aggregate costs of harm and abatement.
Another type of argument that might be relevant and could serve as a counter-argument to the free allocation of allowances, is that such allocation contradicts the Polluter Pays Principle (PPP). This principle has been invoked by governments on numerous occasions over the years. However, the PPP comes in a narrow and a wide version. The narrow version says that the polluter should bear his own abatement costs and thus rules out the bribe option. This does not tell us anything about free allocation versus auctions, The wide version of the PPP has relevance as a theoretical idea, but is not supported by actual law or policies in any consistent way. This version states that all harm should correspond to financial expenditures for the firm. However, this version lacks support in actual legal policy-making practices. So far, a consistent set of optimal environmental taxes has not been put into effect. Industrial pollution is mainly regulated through a concession system, and the civil liability for the firms are then regulated not by pure strict liability, but through a system of tolerance limits with entails a doctrine of reasonable use. Thus, the wide version of the PPP is far removed from the preferences of the political community as revealed through actual legislation. In this situation, it is not clear why we should accord it independent weight in the evaluation under the criterion of cost-effectiveness.
It might be argued that the polluters should pay upfront for the allowances in order to keep size of the polluting sectors down. It might seem that free allocation is insufficient in this respect, since the allowances would be withdrawn if the plant shuts down. Thus, the incentive to shut down would be too small, and the polluting sectors too large. However, as long as the total emissions allowed over time are somehow kept within the fixed cap, this should not be a problem in aggregate. Moreover, a real PPP system would also be imperfect in that it is subject to the excess burden problem and thus may lead to too many shut-downs.
In sum, the conclusion must be that it is not a clear inconsistency between cost-effectiveness as the main rationale behind greenhouse gas emission trading and the choice to allocate alienable allowances without compensation. As already mentioned, this conclusion may be relevant for the application of state aid rules, and it may be that Norway and EU members have paid insufficient attention to the implications of this point in the structuring of their emission trading systems. A “property approach” to allocation plans might work, but this would have to be developed elsewhere.
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