Tacit Agreement and Relationship-Specific Investment

Clayton P. Gillette

Default rules of contract law permit recovery of consequential damages for breach when the breaching party had “reason to know” of those damages at the time of contracting. It is a common observation that sophisticated parties systematically bargain out of these default rules, since the scope of consequential damages is highly uncertain and largely within the control of the non-breaching party. Nevertheless, some parties retain the default rules, and some contracts involving sophisticated actors contain an explicit provision allowing consequential damages, including lost profits, for breach. In effect, these parties satisfy the test that awards consequential damages only when there has been “tacit agreement” to their recovery. That test, which has been repudiated by commentators and most case law outside of New York, limits recovery of consequential damages more severely than the standard “reason to know” test. In this Article, I examine contracts that include explicit “lost profits” clauses and cases in which courts have determined whether parties either tacitly agreed to or had reason to know of prospective lost profits. I claim that the relevant contracts and cases reveal that consequential damage clauses are used to solve a contracting problem that might otherwise frustrate mutually beneficial exchange. Parties and courts have perceived that a commitment to pay lost profits can diminish the threat of opportunistic behavior that is inherent where one party must make a relationship-specific investment prior to performance by the counterparty. In transactions with those characteristics, the investing party risk  holdup by its counterparty between the period when the initial investment is made and when the second party must act. I suggest that a commitment to pay lost profits in the event of breach constrains the threat of holdup, and that in these circumstances the value of the promise compensates for the efficiency loss otherwise inherent in assigning consequential damages to the party least able to avoid them. While a pledge of lost profits in the event of breach is not the exclusive response to this holdup problem, it is a plausible and perhaps superior means of avoiding it. I conclude that the combination of near-universal opt-out of the default rule for consequential damages and the explicit adoption of a broad consequential damages clause in investment cases indicates that the “tacit agreement” test may be more consistent with the preferences of commercial parties for a contract default rule than the “reason to know” test.

This article appears in the April 2013 Issue: Volume 88, Number 1