Tuesday, March 24, 2009

A Contract Case

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.

1 comment:

  1. A contract is an exchange of promises between two or more parties to do.
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