OHIO STATE LAW JOURNAL Volume 59, Number 2, 1998 Disproportionality and the Law of Consequential Damages: Default Theory and Cognitive Reality LARRY T. GARVIN* Hadley v. Baxendale's limits on a plaintiff's ability to recover consequential damages resultingfrom a breach of contract by now are quite familiar.Less familiar, but increasingly important, is an additional limit which focuses on the disproportionality between the contract price charged and the consequentialdamages which that breach induced. This limit, which has a long history, may be found in the Restatement (Second) of Contracts, and has been adoptedby a good many states; moreover, the currentdraft of revised Article 2 of the Uniform Commercial Code contains it. Disproportionalityis largely, if not entirely, unjustifiable when looked at with the standardeconomic tools of default ride analysis, in particularproblem- solving default analysis and information-forcing default rule analysis. Under either, Hadley by itself is more efficient than Hadley with disproportionality,at least under the great majority of plausible scenarios-those with a high- magnitude, low-probability risk. Standard default theory, however, assumes that economic actors will behave rationally. Recent work in cognitive psychology and experimental economics suggests otherwise. Even seasoned businesspeople will frequently underestimate remote risk, which would cause them to charge too low a premium for bearing the risk. The types of risk that are most prone to underestimation-those that the promisor finds infrequent, remote, obscure, and unfamiliar-are the ones that are hence most appropriate for a disproportionalitytest, though one thatfocuses on the disparity between the size of the risk and the size of the premium charged to bear it. I. INTRODUCTION Hadley v. Baxendale1 is probably the one case that every common-law lawyer may be assumed to have read.2 Its facts-a miller sent his broken * Assistant Professor, Florida State University College of Law. B.A., B.S., Michigan State University; M.S., University of Michigan; J.D., Yale Law School. My thanks to Mark Seidenfeld for his helpful comments, Susan Bloodworth and Kasandra Derry for their doughty research assistance, and Patricia Simonds, Mary McCormick, and the rest of the library staff for their aid and forbearance. 1 156 Eng. Rep. 145 (Ex. 1854). 2 Cf CHRLES L. KNAPP & NATHAN M. CRYSTAL, PROBLEMS INCotrRmcr LAw 917 OHIO STATE IAW JOURNAL [Vol. 59:339 millshaft for repair, and the carrier's delay cost him lost profits from the mill's closure-may be all too familiar, evoking Kingsfieldian memories of a first- year contracts class. More importantly, we still look to Hadley as the key to the law of consequential damages, with every law student at some point learning the two tests from Hadley: that a party seeking consequential damages must show either (1) that the damages flowed naturally from the breach of contract, or (2) that the damages, though not flowing naturally, were nevertheless foreseeable by the contracting parties at the time of contracting.3 And, as usual in contract law, we can look to the Uniform Commercial Code (U.C.C.) and the Restatement (Second) of Contracts for clear statements of familiar black- letter law. Or can we? Consider first the Restatement (Second). True, the pertinent 4 section-number 351-starts with something like the test we know and love. Its first subsection starts with an oddly negative version of a foreseeability test: "Damages are not recoverable for loss that the party in breach did not have reason to foresee as a probable result of the breach when the contract was made." 5 Of course, foreseeability is an elusive term, with its meaning dependent upon the legal context in which it is used. 6 So.the next subsection defines a foreseeable loss as one that "follows from the breach (a) in the ordinary course of events, or (b) as a result of special circumstances, beyond the ordinary course of events, that the party in breach had reason to know." 7 Put together, these subsections amount to little more than Hadley, somewhat (3d ed. 1993) (" [Hadley is] one of the few cases that probably all students of contract law in this century have learned to remember by name, even if (as may be likely) they eventually forget what it stands for."). The only real rivals for this status are Rylands v. Fletcher, 3 L.R.-E. & I. App. 330 (H.L.1868), and, at least in the United States, Palsgraf v. Long IslandR.R., 162 N.E. 99 (N.Y. 1928) (Cardozo, C.J.). Unaccountably, United States ex rel. Mayo v. Satan and His Staff, 54 F.R.D. 282 (W.D. Pa. 1971), is not in this number. 3See Hadley, 156 Eng. Rep. at 145. 4 Or loathe. See, e.g., Thomas A. Diamond & Howard Foss, ConsequentialDamages for CommercialLoss: An Alternative to Hadley v. Baxendale, 63 FORDHAM L. REv. 665 (1994) (criticizing the Hadley test and proposing an alternative); Melvin Aron Eisenberg, The PrincipleofHadley v. Baxendale, 80 CAL. L. REv. 563 (1992) (same). 5 RESTATEMENT (SECoND) OF CONTRACrs § 351(1) (1979). 6Consider, for example, the substantial difference between foreseeability in contract- the Hadley test-and foreseeability in tort-more or less proximate cause. See, e.g., Koufos v. C. Czarnikow Ltd. [The Heron HI], [1969] 1 App. Cas. 350, 385-87 (1967) (appeal taken from Eng.) (opinion of Lord Reid) (distinguishing tort foreseeability from contract); LEON GREEN, RATONAm OF PROXIMATE CAUsE 44-55 (1927) (same); H.L.A. HART & TONY HONoR1 , CAUSATION INTHE LAW 308-24 (2d ed. 1985) (same). 7RESrATEmENT (SECOND) OF CoNTCrs § 351(2) (1979). 1998] DISPROPORTIONALITY loosened, with the two familiar tests in the familiar order. But then we come to the third subsection, which may surprise even those who remember clearly their contracts class. There we get a limit on the two familiar tests: that even foreseeable consequential damages may not be recoverable if the court "concludes that in the circumstances justice so requires in order to avoid disproportionate compensation." 8 What is this? Surely nothing from Hadley. Nor does the comment orient us any better, with its references to the informality of dealing and the commercial nature of the parties as factors in determining whether liability should be placed on the promisor. 9 Perplexed, we flip quickly to Article 2 of the U.C.C. There we breathe a sigh of relief, seeing something like the traditional Hadley rule firmly in place.' 0 But, aware that Article 2 is being revised, and now wary of over- reliance on our recollections, we look up the current draft of Article 2.11 What do we find when we see the revised text? The disproportionality language from 12 the Restatement (Second). Now, wait just a moment. For a case so well known as Hadley, and a doctrine so firmly established, this review has tuned up more surprises than one would have thought. After all, contracts classes usually do not reach this disproportionality analysis, 13 and the assiduous reader of law reviews-if any 8 RESTATEMENT (SECOND) OF CONTRACTs § 351(3) (1979). Somewhat similar provisions exist in many state civil codes, typically based on the early Field Code. See CAL. Civ. CODE § 3359 (West 1970) (only reasonable damages are recoverable when an obligation "appears to create a right to unconscionable and grossly oppressive damages, contrary to substantial justice"); MONT. CODE ANN. § 27-1-302 (1995) (same); N.D. CENT. CODE § 32- 03-37 (1996) (same); OKLA. STAT. ANN. tit. 23, § 97 (West 1987) (same); S.D. CODmmD LAWS § 21-1-3 (Michie 1987) (same); see also N.Y. Civ. CODE § 1878 (1865) (substantially similar). 9 See R SrATEmENT (SECOND) OF CoNTRAcrs § 351 cmt. f (1979). 10 See U.C.C. § 2-715(2) (1995). 11 See U.C.C. § 2-806(b) (Tentative Draft, Mar. 1, 1998). 12 See id. 13 Of the roughly two dozen contracts casebooks on the market, only nine contain a case or comment that discusses disproportionality at all, and only two of these discuss it at any length. See JAMES F. HOGG & CARTER G. BISHOP, CONTRAcTs: CASES, PROBLEMS AND MATmUALS 476-87 (1997) (containing a case directly addressing disproportionality); DAVID H. VERNON, CONTRACTS: THEORY AND PRAcICE 320-32 (2d ed. 1991) (same); see also JOHN P. DAwsoN Er AL., CASES AND COMMENT ON CONTRACTs 68-69 (6th ed. 1993) (containing a case indirectly addressing disproportionality); ROBERT W. HAMILTON ET AL., CONTRAcTS: CASES AND MATERIALS 59-62 (2d ed. 1992) (same); FRIEDRICH KESSLER Er AL., CONTRACTS: CASES AND MATERIALS 1152-57 (3d ed. 1986) (same); KNAPP & CRYSTAL, supra note 2, at 936 (noting the disproportionality limitation on consequential damages); EDWARD J. MURPHY Er AL., STUmis IN CONTRAcr LAw 919 (5th ed. 1997) OHIO STATE LAW JOURNAL [Vol. 59:339 14 such person exists-would have little to recall on the issue. So is disproportionality a weird academic fancy, of little interest to practical lawyers? Actually, no. Bear in mind that revised Article 2 of the U.C.C. is likely to contain disproportionality as a part of its rules on consequential damages. 15 The 16 U.C.C. is not merely precatory; it is the law of all our common-law states. Should the revision enjoy the popularity of the original, then virtually all domestic sellers of goods will have to face this rule. 17 And we find (same); JOHN EDWARD MURRAY, JR., CoNnrAcrs: CAsEs AND MATERIus 669 (4th ed. 1991) (same); ARTHUR RosErr, CONTRACt LAW AND ITS APPIUCATON 326 (4th ed. 1988) (same); ROBERT S. SUMMERs & ROBERT A. HILmAN, CONTRACr AND REiATED OBIGATION: THEORY, DOCTRINE, AND PRACrlCE 257 (3d ed. 1997) (quoting Restatement (Second) of Contracts § 351(3)). 14 Since the Restatement (Second) came forth in 1979, only three articles have focused on disproportionality (though a number of others have mentioned it in passing).