Consumer surplus

What is it?

‘Consumer surplus’ is an economic term, referring to the difference between what someone would have been ready and willing to pay for a particular item and what they actually ended up paying for it.

The irrelevance of consumer surplus to contract damages

As we will see, it has been suggested by some academics and judges that in a breach of contract case, the damages payable to the victim of the breach may in some way reflect or protect the victim’s consumer surplus. This is untrue.

Suppose that you contract to sell me a ticket to a Bruce Springsteen concert for £100. I would have been ready and willing to pay £300 for a ticket (I’m relatively well off, and love The Boss), so my consumer surplus on this transaction is £200. You then tell me that you won’t be able to get me a ticket for the concert after all – your supplier of Springsteen tickets has let you down.

If I can get a ticket from another source for, say, £150, then you will be liable to pay me £50 in damages: the difference between what I would have paid you had you properly performed, and what I’ve ended up having to pay someone else for what I entitled to from you.

If I can’t get a ticket from another source to the concert, then – as this was a contract for fun – I’ll be entitled to sue you for damages for the loss of enjoyment of attending the concert. Awarding such damages requires the court to put a monetary value on how much I would have enjoyed attending the concert. Some might argue that this should be assessed according to how much I would have been ready and willing to pay for a ticket (£300) – but this is a mistake. How much I would have been ready and willing to pay for a ticket not only reflects my assessment of how much I would enjoy going to a Bruce Springsteen concert, but also how much money I have got in my pocket. So I might value the enjoyment of attending a Bruce Springsteen concert at £1,000, but only have been ready and willing to pay £300 for a ticket because I simply don’t have enough money to be able to afford to splash out £1,000 on a Bruce Springsteen concert. One way of putting a monetary value on how much I would have enjoyed attending the concert is to ask – Once I had the ticket, how much would I have been willing to sell it for? It makes sense that I would not have sold the ticket for less than the monetary value that I put on the enjoyment of attending the concert. It’s highly unlikely that once I got the ticket to go to the Bruce Springsteen concert that I would have been willing to sell it just for £300. It’s likely that I would only have been ready and willing to sell the ticket for a lot more money than I would have been ready and willing to buy the ticket for. Let’s say that had I got the ticket, I would have been ready and willing to sell it to someone else for £750. In that case, we should value my loss of enjoyment from not attending the concert at £750 and award me £650 in damages – £750 minus the £100 I have saved as a result of your breach because I no longer have to pay you for the ticket.

So – if you breach your contract with me to supply me with a ticket to the Bruce Springsteen concert, I will either be able to sue you for £50 (if I can get a ticket from another source) or £650 (if I can’t). In neither case can I sue you for £200 – which is my consumer surplus on my transaction with you. My consumer surplus is completely irrelevant to how much I might be able to sue you for.

Consumer surplus in the cases

Despite this, there are a number of cases which say that damages awards in breach of contract cases can be designed to protect the victim of breach’s ‘consumer surplus’.

In Ruxley Electronics and Construction Ltd v Forsyth (1996), Lord Mustill said that ‘the law must cater for those occasions where the value of the promise to the promisee exceeds the financial enhancement of his position which full performance will secure. This excess, often referred to in the literature as the “consumer surplus”…is usually incapable of precise valuation in terms of money, exactly because it represents a personal, subjective and non-monetary gain. Nevertheless where it exists the law should recognise it and compensate the promisee if the misperformance takes it away.’

In Farley v Skinner (2002), Lord Steyn observed of Lord Mustill’s judgment in Ruxley that ‘for Lord Mustill…the principle of pacta sunt servanda [contracts must be kept] would be eroded if the law did not take account of the fact that the consumer often demands specifications which, although not of economic value, have value to him. This is sometimes called the “consumer surplus”… Lord Mustill rejected the idea that “the promisor can please himself whether or not to comply with the wishes of the promise[e] which, as embodied in the contract, formed partof the consideration for the price”.’

Lord Steyn did go on to say that ‘Labels sometimes obscure rather than illuminate. I do not therefore set much store by the description “consumer surplus”.’ Quite right too. It is obvious that in these passages the phrase ‘consumer surplus’ is being misused to act as synonym for ‘enjoyment’ or ‘pleasure’. So when we say (1) ‘The law can award damages to compensate the victim of a breach of contract for the loss of his consumer surplus’ all we are actually saying is (2) ‘The law can award damages to compensate the victim of a breach of contract for the loss of the pleasure or enjoyment he would have obtained from proper performance of the contract’. But if that’s the case, then why not say (2) rather than (1)? We should prefer simple words whose meaning is plainly obvious over complex words whose meaning has to be explained. And we should definitely not borrow concepts from another discipline where they have a particular, technical meaning and then use those concepts to say something completely different. Doing so can only make it even more difficult for other people to understand what we are saying.

The source of the problem

The blame for the fact that the language of ‘consumer surplus’ has now crept into judgments on assessing damages for breach of contract in cases where the victim of the breach has suffered a loss of enjoyment (and from there has gotten into the textbooks – where even more confusingly, they sometimes distinguish between a claim in contract for distress and loss of enjoyment, and a claim for loss of one’s ‘consumer surplus’) must be laid squarely at the foot of an article published in the Law Quarterly Review in 1979: Harris, Ogus and Phillips, ‘Contract remedies and the consumer surplus’ (1979) 95 Law Quarterly Review 581. The article is not available online, so I will quote in full from the crucial passage in the article where the authors introduce the concept of ‘consumer surplus’ (while discussing the decision of Oliver J in Radford v De Froberville (1977)). The passage is at pp 582-83 of the article:

‘The existence of the wall on the new boundary of his land [in Radford v De Froberville] was worth more to the plaintiff than the increase which the wall would make to the market value of the land; it was argued that he valued the particular architectural style and privacy it afforded more highly than the average purchaser of the land. This is an example of what economists refer to as “consumer surplus”, the excess utility or subjective value obtained from a “good” over and above the utility associated with its market price. (As explained below, the consumer surplus expected by a person who intends to use a good is equivalent to the profit which a businessman expects to make from the contract.) The concept of consumer surplus is important in any attempt to measure consumer losses because, unlike firms, consumers make purchases for the pleasure or utility they confer; this utility has no necessary relationship with the price paid and is of a quite different order from market prices or business profits. It is, of course, difficult to measure utility, but generally economists avoid the conceptual problem by measuring utility in terms of the maximum amount a consumer would pay for a particular purchase. For instance, if a purchaser can buy a plot of land for £1,000, when he would be prepared to pay up to £1,500 for it, the extra £500 represents his “consumer surplus”.’

Notice how the authors end up correctly defining how a purchaser’s ‘consumer surplus’ on the purchase of land is assessed. But for the whole of the rest of the passage, ‘consumer surplus’ is simply identified with the difference between how much pleasure or enjoyment (or, in the authors’ language, ‘utility’) one will obtain from a good, and how much you have paid for that good. That is not how economists define the term ‘consumer surplus’, but unfortunately that does seem to be the definition that has crept into the cases (and from there the textbooks), via the Harris, Ogus and Phillips article.

It is time to stop the rot. Lawyers should stop talking about ‘consumer surplus’ and stick to their knitting. When they are actually talking about damages being awarded for loss of enjoyment or pleasure then they should actually talk in terms of damages being awarded for loss of enjoyment or pleasure. And students should do the same in writing essays and problem answers and avoid at all costs using the phrase ‘consumer surplus’ (unless positively required to do so by the terms of the essay or problem question).

The beneficiary principle

What is it?

The cases disclose two versions of the beneficiary principle: the strong version and the weak version.

(1) The strong version of the beneficiary principle says that a non-charitable trust cannot exist unless there are one or more identified individuals who have a beneficial interest in the trust property. Lord Parker endorsed this strong version of the beneficiary principle when he said in Bowman v Secular Society Ltd (1917) that ‘A trust to be valid must be for the benefit of individuals, which this certainly is not, or must be in that class of gifts for the benefit of the public which the courts in this country recognise as charitable…’

(2) The weak version of the beneficiary principle says that a non-charitable trust cannot exist unless there exists someone with the power to enforce the obligations of the trustee. The original formulation of the beneficiary principle in Morice v Bishop of Durham (1804), by Sir William Grant, seems to endorse the weak version of the beneficiary principle: ‘There can be no trust, over the exercise of which this Court will not assume a control; for an uncontrollable power of disposition would be ownership, and not trust… Every…trust [other than a trust for charity] must have a definite object. There must be somebody, in whose favour the Court can decree performance.’

Viscount Simonds’ statement of the beneficiary principle in Leahy v Attorney General for New South Wales (1959) seems to straddle both views. In discussing the validity of a gift for the ‘general purposes’ of an association, Viscount Simonds observed, ‘If the words “for the general purposes of the association” were held to import a trust, the question would have to be asked, what is the trust and who are the beneficiaries? A gift can be made to persons…but it cannot be made to a purpose or to an object: so also, a trust may be created for the benefit of persons as cestuis que trust but not for a purpose or object be charitable.’ So far, so compatible with the strong version of the beneficiary principle. But Viscount Simonds then went on to say: ‘For a purpose or object cannot sue, but, if it be charitable, the Attorney-General can sue to enforce it.’ This seems to take the view that the beneficiary principle will be satisfied if there is someone who can sue to enforce the duties of the trustee of a non-charitable trust.

The trust in Re Denley

The decision in Re Denley and its subsequent reception illustrates the difference between the strong and weak versions of the beneficiary principle. The facts of the case are complicated, but for our purposes we can take it that the question Goff J had to decide was whether a company had created a valid trust when it settled land on trustees to be used as a sports ground ‘mainly for the benefit of employees of the company’. Goff J observed that:

‘I think there may be a purpose or object trust, the carrying out of which would benefit an individual or individuals, where that benefit is so indirect or intangible or which is otherwise so framed as not to give those persons any locus standi to apply to the court to enforce the trust, in which case the beneficiary principle would, as it seems to me, apply to invalidate the trust…the beneficiary principle is [directed at] purpose or object trusts which are abstract or impersonal.’

This seems to endorse the weak version of the beneficiary principle, and open the door to recognising that a non-charitable purpose trust is valid if there exists someone who has enough of an interest in the purpose of the trust being fulfilled that they could be given standing to enforce the trust, and could be trusted to exercise their powers to enforce that trust. And Goff J could be said to have walked through that door when he upheld the trust in Re Denley as valid on the basis that ‘the employees [were to] be entitled to the use and enjoyment of the land.’ As such, Goff J held, the trust in Re Denley was ‘directly or indirectly for the benefit of an individual or indviduals’ and as such it ‘fell outside the mischief of the beneficiary principle.’

However, later cases have not adopted this interpretation of Goff J’s decision in Re Denley. Instead, they have read Goff J as holding that the trust in Re Denley did not offend against the strong version of the beneficiary principle. In other words, Re Denley has been interpreted as holding that the land in Re Denley was held on trust for the employees for the duration of the trust. On this reading, Goff J found in Re Denley that the land was held on trust for the employees, who had a beneficial interest in the land. In other words, the Re Denley trust was a persons trust, not a purpose trust. Vinelott J interpreted Re Denley in this way in Re Grant’s Will Trusts (1980), holding that in Re Denley Goff J ‘held that the trust deed created a valid trust for the benefit of the employees, the benefit being the right to use the land subject to and in accordance with the rules made by the trustees.’ Vinelott J did not see anything at all unorthodox about such a trust: ‘I can see no distinction in principle between a trust to permit a class defined by reference to employment to use and enjoy land in accordance with rules to be made at the discretion of trustees on the one hand, and, on the other hand, a trust to distribute income at the discretion of trustees amongst a class, defined by reference to, for example, relationship to a settlor.’ Of course, under a discretionary trust, the class of potential beneficiaries is regarded as collectively having a beneficial interest in the trust property, and similarly, the employees in Re Denley could be regarded – on this analysis – as having collectively a beneficial interest in the land in Re Denley. A similar view of Re Denley was adopted by Lawrence Collins J in Re Horley Town Football Club (2006), holding (at [99]) that the land in Re Denley was held on ‘trust for the benefit of individuals’.

The anomalous exceptions

Whichever version of the beneficiary principle we endorse – and whatever view we take of Goff J’s judgment in Re Denley – there are some trusts that stand as exceptions to the beneficiary principle. These were listed in Re Endacott (1960) as ‘(1) trusts for the erection or maintenance of [funerary] monuments or graves; (2) trusts for the saying of masses…; (3) trusts for the maintenance of particular animals…’ These non-charitable trusts will be valid despite the fact that no one will have a beneficial interest in the trust property and it is not obvious who will be able to enforce these trusts.

So why do these exceptions to the beneficiary principle exist? The cases reveal two explanations. The first is that the courts simply screwed up when they recognised these trusts as being valid. This view was put forward most strongly by Harman LJ in Re Endacott, holding that these exceptions owe their existence to ‘occasions when Homer has nodded’ (i.e. the courts have gone to sleep and stopped thinking straight) and that they are ‘troublesome, anomalous and aberrant cases.’ The second view was put forward by Roxburgh J in Re Astor (1952) – that if you look at the cases where these anomalous trusts were recognised as being valid, in most of those cases, the trust under examination did not in fact violate the weak version of the beneficiary principle, in that there did exist someone who had the power to go to court to ensure that the trustee of the trust was not misappropriating the trust property.

In fact, there is a much more satisfying explanation of these exceptions, which focusses on the fact that they are often referred to as ‘concessions to human weakness or sentiment’. These exceptions to the beneficiary principle owe their existence to the fact that people cannot be stopped from trying to create these kinds of trusts in their wills. If you are making a will, you will want to set some money aside for the maintenance of your grave and the erection of a headstone (assuming that you can’t count on anyone else to do this, and you don’t want your name to disappear into oblivion once you die); and you will want to set aside some money for the care of your pets; and if you believe in Heaven and Hell and you aren’t certain where you are going to end up after you die, you will most definitely want to set aside some money for masses to be said for your soul. Now the courts could react to the fact that are going to put such trusts in their wills by taking a hard line and saying ‘These trusts are invalid.’ But that would be futile – people will simply not be deterred from inserting these kinds of provisions into their wills by a warning that these provisions will not be given effect to by a court. So what? they might think – I might as well make these stipulations, and just hope that they are put into effect. Recognising this, the courts have bowed to consumer demand and held that these kinds of purpose trusts – but (as was held in Re Endacott) only these kinds of purpose trusts – will be held to be valid despite the fact that they are not charitable in nature and violate the beneficiary principle.

Which version of the beneficiary principle should we prefer?

No one is in favour of abolishing the weak version of the beneficiary principle. The idea of upholding a trust when there is no effective means of ensuring that the trust property is not misapplied is not one that anyone favours. So the only issue relating to the beneficiary principle is whether we should give effect to the strong version of the beneficiary principle, in preference to the weak version. This depends on how we answer the Validity of Non-Charitable Purpose Trusts Question: Should we hold that a non-charitable purpose trust is valid provided that there exists an ‘enforcer’ who has standing to compel the trustee to apply the trust property for the purpose for which it was transferred to him? If our answer is ‘no’ then we are effectively in favour of the strong version of the beneficiary principle: the only sort of non-charitable trust we are willing to find is valid is a trust for persons, not a trust for purposes. If our answer is ‘yes’ then we have effectively rejected the strong version of the beneficiary principle and accepted the weak version of the beneficiary principle.

English law – Re Denley notwithstanding – has effectively said ‘no’ to the Validity of Non-Charitable Purpose Trusts Question. English law will not recognise a non-charitable purpose trust as being valid, even if there exists a queue of people ready and willing to acts as ‘enforcers’ to compel the trustee of the trust to apply the property for the purpose for which he has been given it. A number of jurisdictions elsewhere in the world have taken a different view: notably the Cayman Islands (with its Special Trusts (Alternative Regime) Law 1997 – non-charitable purpose trusts that are recognised as valid under the 1997 Law are usually referred to as ‘STAR’ trusts); but also Bermuda, the British Virgin Islands, the Isle of Man, Guernsey, Mauritius, and Brunei.

Academic opinion on how the Validity of Non-Charitable Purpose Trusts Question should be answered is also divided. David Hayton (‘Developing the obligation characteristic of the trust’ (2001) 117 Law Quarterly Review 96)  and Jonathan Hilliard (‘On the irreducible core content of trusteeship – a reply to Professors Matthews and Parkinson’ (2003) 17 Trust Law International 144) say ‘yes’; while Paul Matthews (‘The new trust: obligations without rights’ in Oakley (ed), Trends in Contemporary Trusts Law (1996), and ‘From obligation to property and back again? The future of the non-charitable purpose trust’ in Hayton (ed), Extending the Boundaries of Trusts and Similar Ring-Fenced Trusts (2002)) and Patrick Parkinson (‘Reconceptualising the express trust’ (2002) 61 Cambridge Law Journal 657) say ‘no’.

Here are three arguments in favour of responding ‘no’ to the Validity of Non-Charitable Purpose Trusts Question that you should consider in making up your own mind as to how you would answer this question:

(1) The capriciousness argument. In Brown v Burdett (1882), a testatrix provided in her will that her house should be bricked up and people generally prevented from entering it for twenty years after the death. During the twenty years, the house was only to be occupied by ‘some respectable married couple’ who would occupy ‘the kitchen, back-kitchen, middle attic and hall’ and who would look after the house and generally make sure that no one else could enter it. After the twenty years were up, the house would be inherited by various heirs, so long as they made sure that the house was kept empty of visitors for the twenty years immediately after the testatrix’s death. The trust to keep the house in Brown empty satisfied the weak version of the beneficiary principle, insofar as her ultimate heirs had an incentive to ensure that the trustees of the testatrix’s will had ample incentive to ensure that the trustees complied with her instructions to keep the house empty of visitors. Despite this, the trust was declared invalid. Bacon V-C held that ‘I think I must “unseal” this useless, undisposed of property’ and gave a declaration that the house was ‘undisposed of by the will, for the term of twenty years from the testatrix’s death.’ (That is literally all he said.) The case of Brown v Burdett illustrates one of the dangers involved in declaring non-charitable purpose trusts to be valid, so long as the weak version of the beneficiary principle is satisfied. You could end up requiring that valuable property be used for purposes that are completely capricious (which, in this context, means ‘useless’ – for another meaning, see the essay on the creation of express trusts, elsewhere on this website). (Many thanks to W.S. for referring me to the case of Brown v Burdett.)

(2) The economic argument. Even if the purpose for which property has been left on trust is not capricious, and is intelligibly valuable, requiring that the property be applied for that purpose is potentially inefficient in that it could tie up property so that it can only be used for a particular purpose for the perpetuity period (in this context, 21 years) when its being used for some other purpose would be much more productive. For example, there are no guarantees that the most beneficial use of the land in Re Denley was that it be used as a sports ground for a company’s employees. Maybe converting the land into a housing estate would have been more beneficial. A free market economy seeks to ensure that property ends up being used for the most beneficial purpose by allowing property to gravitate into the hands of those who are ready and willing to pay the most for the property. (The idea being that those who can make the most socially productive use of property are those who will be and ready and willing to pay the most for that property; a very questionable assumption, but no better yardstick for measuring the social worth of the way someone proposes to uses a particular piece of property has even been arrived at.) Non-charitable purpose trusts get in the way of the free market distributing property into the hands of those who are ready and willing to pay the most for that property by requiring that that property be used for a particular purpose, and only for that purpose, during the perpetuity period. It is for this reason, I believe, that law requires that a purpose trust be for the ‘public benefit’ before it will declare that the trust is valid as a charitable trust. Before the courts will tie up the property to be used for a particular purpose (for perpetuity), they will require it to be established that using that property for that purpose will be of some proven benefit to the public benefit that will outweigh the possible detriment to the public resulting from the property being tied up so that it cannot be used for any other benefit.

(3) The tax avoidance argument. It seems to be no accident that all of the jurisdictions that allow settlors to create non-charitable purpose trusts are notorious tax havens: countries that make it easy for rich people who are willing to deposit their money in the country’s banks to structure their affairs so as to minimise the amount of tax they have to pay on that money. Non-charitable purpose trusts are a wonderful device for avoiding tax. In a jurisdiction that recognises the validity of non-charitable purpose trusts, S can settle money and shares on T to be used for the non-charitable purpose of ‘looking after the needs of S, his family and close relatives’. As S etc. (and T) do not have a beneficial interest in the money and shares that are held on this non-charitable purpose trust, they cannot be taxed on the income earned by the money and shares. And any disbursements they receive from the trust fund will count as gifts from the trust fund, and so will not be taxable on receipt. Companies can also use non-charitable purpose trusts to minimise their taxes. For example (an example drawn from Alexander Bove, ‘The purpose of purpose trusts’ (2004) 18 Real Property, Probate and Trust Law Journal 34), in a jurisdiction that recognised non-charitable purpose trusts as being generally valid, a company could set up a non-charitable purpose trust, the purpose of which trust would be to lease the company equipment. (The company would then act as ‘enforcer’ of the trust to ensure that the weak version of the beneficiary principle is observed.) The trustees of the trust then purchase a piece of machinery which the company needs. The company leases the machinery from the trustees of the trust fund, thereby repaying the trust fund for the money it has spent on the piece of machinery. But the machinery – being leased – does not appear on the company’s balance sheet, and the lease payments count as a loss on the company’s accounts, thereby diminishing the profits it has to declare, and the amount of tax it has to pay on those profits. (For those interested in exploring issues relating to tax avoidance, Nicholas Shaxson’s website is as good a starting point as any. Nicholas Shaxson wrote Treasure Islands: Tax Havens and the Men Who Stole the World (2012) – an eye-opening look at the history and reality of countries’ setting themselves up as tax havens for rich people from around the world.)

The rule in Hadley v Baxendale

What is it?

The rule in Hadley v Baxendale basically says that if A has committed a breach of a contract that he has with B by doing x, and B has suffered a loss as a result, that loss will count as too remote a consequence of A’s breach to be actionable unless at the time the contract between A and B was entered into, A could have been reasonably been expected to foresee that his doing x was likely to result in B suffering that type of loss, because either: (1) it would have been quite normal or natural for B to suffer that type of loss as a result of A’s doing x; or (2) A was informed before he entered into the contract between him and B of any special circumstances which meant it was likely that A’s doing x would result in B suffering that type of loss.

Why do we have it?

The rule in Hadley v Baxendale is basically a rule of fairness; one of about ten different features of the English contract law that can be seen as requiring the parties to a contract to deal fairly with each other. The reason why we have the rule in Hadley v Baxendale is to give each contracting party a fair chance to decide whether or not they want to enter into the contract, and if so on what terms. A would be deprived of that chance if he were held liable for a loss suffered by B as a result of A’s breach of contract when he had no way of knowing at the time the contract was entered into that B stood to suffer that type of loss if he breached. Had A known this, and known that he might be held liable for that loss, he might have refused to enter into the contract with B, or bargained for an alteration in the terms of the A-B contract to protect himself against being held liable for that loss, or to reward him for running the risk of suffering that loss. As Alderson B remarked in Hadley v Baxendale (1854) itself, of the case where B suffers a loss as a result of A’s breach due to special circumstances that A was unaware of at the time he entered into his contract with B,

‘…had the special circumstances been known, the parties might have specially provided for the breach of contract by special terms as to the damages in that case, and of this advantage it would be very unjust to deprive them.’

A concrete example can make this point clear. Suppose that Loaded enters into a contract with Builder for the construction of a swimming pool in Loaded’s country house. The contract specifies that the swimming pool must be ready for use by June 1st. A few days after the contract is entered into, Loaded tells Builder that he needs the swimming pool to be installed by June 1st because a movie company is taking over his estate during the summer to do some filming in and around it, but they have made it a condition of their contract with him that he have a swimming pool installed as a number of crucial scenes take place in and around a swimming pool. Loaded also tells Builder that the movie company are paying him ‘crazy money’ – £5m – to hire his estate from June 15th – September 15th. Builder does not complete the swimming pool until July 1st, and Loaded’s deal with the movie company falls through.

At the time Builder breached his contract by failing to complete the swimming pool on time, it was perfectly foreseeable that his doing so would result in Loaded suffering a loss of £5m. However – unlike the position in tort law (most of the time) – we do not determine the remoteness or otherwise of a loss suffered as a result of a breach of contract by looking at what was foreseeable at the time the breach occurred. Instead, we look at what was foreseeable at the time the contract was entered into. The reason is that not to do so would be unfair on Builder. Had Builder known that his failing to complete the swimming pool on time might result in his being held liable for the loss of Loaded’s  deal with the movie company, he might have refused the job completely, or negotiated a much higher price for getting the work done on time, or insisted that there be a clause in the contract limiting the scope of his liability. So fairness demands that Builder only be held liable for the losses that he could have contemplated that Loaded might have suffered as a result of his failing to build the pool on time at the time Builder entered into his contract with Loaded, as those were the only losses Builder could have taken the risk of being held liable for when he decided to enter into a contract with Loaded, and on what terms.

The letter and the spirit of the rule

For the most part, giving effect to the letter of the rule in Hadley v Baxendale will also give effect to the spirit of fair dealing that underlies the rule. Where the two diverge, though, is where A enters into a contract with B, knowing that B is likely to suffer a particular kind of loss if A breaches that contract, but A does not factor that knowledge into his decision as to whether or not to enter into his contract with B.

If A’s breach does result in B suffering that kind of loss, the letter of the rule in Hadley v Baxendale indicates that A should be held liable for that loss: at the time A entered into his contract with B, it was reasonably foreseeable that if A breached his contract with B, then B would suffer that type of loss.

However, the spirit of the rule indicates that A should not be held liable for B’s loss – at least where he wasn’t at fault for not factoring in the prospect of B’s suffering that type of loss into his decision as to whether or not to contract with B, and if so on what terms. The reason is that holding A liable for that kind of loss would mean that he wasn’t given a fair chance to consider whether or not he should contract with B, and if so on what terms. Had A taken seriously the prospect that he might be held liable for the sort of loss that B has suffered as a result of A’s breach, he might have refused to contract with B, or have contracted on different terms. As he did not take that prospect seriously – and, apparently, acted reasonably in failing to take that prospect seriously – he should not be held liable for the loss that B has suffered.

So the letter and the spirit of the rule in Hadley v Baxendale will go in different directions in the situation where a contracting party foresees that the other party might suffer a particular type of loss if the contract was breached, but does not factor in the prospect of being held liable for that loss in deciding whether or not to enter into the contract, and if so on what terms. But when would such a situation arise?

The Achilleas (2008)– otherwise known as Transfield Shipping v Mercator Shipping – apparently presented one such situation. The defendants hired a ship from the claimants. The ship was due to be given back on May 2 2004. Expecting to get the ship back by May 2 at the latest, the claimants agreed on April 21 to hire out the ship for 191 days to Cargill International SA for $39,500 a day, with the period of hire to start once the claimants got their ship back from the defendants. Under the agreement, Cargill had the option of cancelling it if they had not received the ship by May 8. By May 5, the defendants still hadn’t handed the ship back to the claimants, and there was no prospect of the claimants getting it back by May 8. Fearful that Cargill would cancel the contract to hire the ship, the claimants renegotiated its terms, extending the cancellation date, but at the same time agreeing to a substantial reduction in the rate of hire for the ship – $31,500 a day rather than $39,500 – to reflect the fact that there had been a sharp fall in the general market rates for hiring ships like the claimants’. The claimants finally got their ship back from the defendants on May 11, nine days late.

The claimants sued the defendants for damages, arguing that ‘Had you not been late redelivering the ship, we would now be hiring out the ship for 191 days to Cargill at $39,500 a day rather than $31,500 a day. So we have suffered a loss of about $1.5m (191 x $8,000) as a result of your breach of contract, and you are liable to us for that loss.’ However, the defendants argued, ‘The custom in the industry is that when a ship is delivered back late, all the owner can sue for is the difference between what he could have earned hiring out the ship during the period the ship was wrongfully retained, and what is due under the hire contract for retaining the ship for that period of that time. So we are only liable for $158,000: the extra amount you could have made during the nine days we retained the ship compared with what we have to pay under our contract of hire for retaining the ship for those nine days.’ If the defendants were right – and this is something that is disputed – that the custom in the shipping industry on late return of a ship was simply to sue for the loss suffered as a result of not being able to hire out the ship to someone else during the period it was detained, then it would have been unfair on the defendants to hold them liable for the $1.5m loss that the claimants suffered because the defendants’ hanging on to the claimants’ ship for nine extra days resulted in the claimants losing out on the chance of hiring the ship out to Cargill for $39,500 a day, as opposed to $31,500 a day. This is because the defendants never seriously contemplated that they might be held liable for that kind of loss when they agreed to hire the claimants’ ship, and had they known that they might be held so liable, they would almost certainly have renegotiated the terms of the contract under which they hired out the claimants’ ship.

So if the defendants were right about the custom in the shipping industry, then The Achilleas was a case where the letter and the spirit of the rule in Hadley v Baxendale might have produced divergent results. According to the letter, whether or not the defendants should have been held liable for the claimants’ $1.5m loss depended on whether the defendants contemplated when they entered into the contract with the claimants that their hanging on to the claimants’ ship beyond the hire period would result in the claimants suffering the kind of loss on the follow-on contract of hire that they suffered here.

On the other hand, if we followed the spirit of the rule in Hadley v Baxendale, then we would regard it as irrelevant whether or not the defendants knew what losses might be suffered by the claimants if the defendants held on too long to the claimants’ ship. If the custom in the industry was such as the defendants described, then the scope of the defendants’ liability should have been determined by that custom. To hold the defendants liable on any other basis, and hold them liable for losses they contemplated the claimants might suffer as a result of breach when they hired the claimants’ ship, would be unfair on the defendants as they never seriously contemplated that they might be held liable for those losses, and did not factor in the possibility that they might be held liable for those losses when they decided to hire the claimants’ ship on the terms they did.

As it happens, the House of Lords did not think that the letter and the spirit of Hadley v Baxendale did diverge in The Achilleas as to what the result of the case should be. Lord Rodger applied the letter of the rule in Hadley v Baxendale and found that at the time the defendants hired the claimants’ ship, there was no reason for them to contemplate that a delay in returning the ship would result in the claimants suffering the type of loss that they had suffered on the follow-on contract as the loss was purely due to ‘unusual’ (at [53]) movements in the market rates for hiring ships. Lord Hoffmann’s approach to the case (which I will discuss in more detail below) was much more consistent with the spirit of Hadley v Baxendale and was – for the reasons explained above – consequently not in favour of holding the defendants liable for the losses suffered by the claimants on their follow-on contract. Baroness Hale agreed with Lord Rodger’s approach, though with some doubts about how it applied in this case. The fact that both approaches resulted in the same outcome allowed Lords Hope and Walker to agree with Lord Rodger and Lord Hoffmann, thus resulting in The Achilleas producing no overall majority in favour of whether the letter or the spirit of Hadley v Baxendale should be followed when they diverge.

And there will be cases where they will diverge in terms of the result they reach. For example: Executive hails a taxi driven by Driver. Executive tells Driver, ‘Take me to the airport. I have a plane to catch in two hours. A huge deal is riding on my making the plane.’ Shortly afterwards, Driver carelessly crashes the taxi. Executive is unharmed but is unable to make his plane, and fails to close the business deal that he was flying out to negotiate; the deal was worth $5m to Executive. Can Executive sue Driver for this loss? According to the letter of the rule in Hadley v Baxendale, yes he can. At the time Driver let Executive into his car, he knew that if he screwed up driving Executive to the airport, that Executive would suffer this kind of loss. According to the spirit of the rule in Hadley v Baxendale, Executive shouldn’t be able to sue Driver for the loss of his deal. At the time Driver let Executive into his car, Driver wasn’t factoring the possibility that he might be sued for that kind of loss into his decision as to whether or not to take Executive to the airport. In fact, Driver wasn’t making any kind of conscious decision as to whether or not to accept Executive as a passenger – as soon as Executive hailed his cab, he was going to take Executive as a passenger, whatever Executive said. Given this, it would be unfair to hold Driver liable for the loss of Executive’s deal. If Executive wanted to be able to sue Driver for that kind of loss, he should have been much more explicit with Driver: ‘Take me to the airport. I have a plane to catch in two hours. There is a huge deal riding on this, and I will sue you for millions if something happens to stop me catching the plane. Are you happy to take me on that basis?’ But if he said something like that, then Driver’s reaction would almost certainly have been: ‘No, I’m not – hop off mate and find someone else to take you.’ Holding Driver liable for the loss of Executive’s deal when that would have been Driver’s reaction had the possibility of his being held liable for that loss been brought home to him illustrates just why the spirit of the rule in Hadley v Baxendale stands opposed to holding Driver liable for that loss.

Where the letter and spirit of the rule in Hadley v Baxendale diverge, which should we prefer? In favour of following the spirit is simple common sense – the letter is supposed to serve the spirit, and must give way when it fails to do this. But in favour of following the letter in all cases is the desire for commercial certainty. Applying the letter of the rule in Hadley v Baxendale across the board may do injustice in individual cases such as Executive v Driver, but it does at least allow litigants in breach of contract cases to know where they stand so far as their potential liabilities are concerned. In contrast, applying the spirit of the rule in Hadley v Baxendale to determine the scope of a contract breaker’s liabilities requires the court to make difficult inquiries into the contract breaker’s expectations when he entered into the contract as to what he might be held liable for if he breached the contract.

Where Lord Hoffmann went wrong in The Achilleas

I said in the preceding section that Lord Hoffmann’s judgment in The Achilleas was ‘consistent’ with the spirit of the rule in Hadley v Baxendale, as I have explained it above. However, this is not quite true. According to the spirit of the rule in Hadley v Baxendale, a defendant should not be held liable for a loss that he did not take the risk of being held liable for when he entered into his contract with the claimant. (Compare the argument of counsel for the defendants in Hadley v Baxendale: ‘Where the contracting party is shewn to be acquainted with all the consequences that must of necessity follow from a breach on his part of the contract, it may be reasonable to say he takes the risk of such consequences.’) Lord Hoffmann said something different in The Achilleas. He said that a defendant should not be held liable for a loss that he did not agree to be held liable for when he entered into the contract (all emphases added):

[12] It seems to me logical to found liability for damages upon the intention of the parties (objectively ascertained) because all contractual liability is voluntarily undertaken. It must be in principle wrong to hold someone liable for risks for which the people entering into such a contract in their particular market, would not reasonably be considered to have undertaken.

[15] …one must first decide whether the loss for which compensation is sought is of a ‘kind’ or ‘type’ for which the contract-breaker ought fairly be taken to have accepted responsibility.

[26] …[in this type of case] the court is engaged in construing the agreement to reflect the liabilities which the parties may reasonably be expected to have assumed and paid for.

The idea that Lord Hoffman seems to be advancing here – that a contract-breaker’s liabilities to compensate the victim of his breach are attributable to the fact that he has agreed to assume those liabilities in entering into the contract – should be rejected as heretical. As Kyle Lawson has brilliantly pointed out (in ‘The remoteness rules in contract: Holmes, Hoffmann, and ships that pass in the night’ (2012) 23 King’s Law Journal 1), Lord Hoffmann’s language in The Achilleas echoes that of Holmes J in deciding the case of Globe Refining v Landa Cotton Oil (1903) in the US Supreme Court. In that case, Holmes J said that:

‘When a man commits a tort he incurs by force of the law a liability to damages, measured by certain rules. When a man makes a contract he incurs by force of the law a liability to damages, unless a certain promised event comes to pass. But unlike the case of torts, as the contract is by mutual consent, the parties themselves, expressly or by implication, fix the rule by which the damages are to be measured… [In considering what the plaintiff is entitled to recover in this case we] have to consider…what liability the defendant fairly may be supposed to have assumed consciously, or to have warranted the plaintiff reasonably to suppose that it assumed, when the contract was made.’

Holmes’ theory of the basis of a contract breaker’s liability followed from his view – famously expressed in ‘The path of the law’ (1896-7) 10 Harvard Law Review 457 – that someone who commits a breach of contract does not actually do anything legally wrong: ‘The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it – and nothing else. If you commit a tort, you are liable to pay a compensatory sum. If you commit a contract, you are liable to pay a compensatory sum unless the promised event comes to pass, and that is all the difference’ (ibid, 462). So the only obligation that a contracting party undertakes is either to ensure that something happens or to pay damages instead. It follows that the contract breaker’s obligation to pay damages is traceable to the fact that the contract breaker undertook to pay such damages if he failed to perform.

All this is nonsense. It is not possible to argue that a contract breaker’s liability to pay damages to the victim of his breach is attributable to the fact that the contract breaker agreed to pay those damages if he did not perform. A couple of examples show this:

(1) A enters into a contract with B. Under the contract, A undertakes to pay B the penal sum of £1m if he breaches his contract in any way at all. On breach, B will not be allowed to sue A for £1m but will instead be confined to suing for the actual loss he has suffered as a result of breach. This is so even though A undertook to pay B £1m if he breached his contract with B, and not to compensate B for his actual loss.

(2) A enters into a contract with B. The contract specifies that A’s liability on breach will be capped at £5,000, whatever the nature of A’s breach, and whatever the extent of B’s losses as a result of A’s breach. It is held that the clause limiting A’s liability is invalid under some statutory provision. A is then held liable for the actual loss suffered by B as a result of A’s breach, even though A never agreed to be held liable for that loss, but only £5,000.

Examples like these show that a contract breaker’s liability to pay damages to the victim of his breach is imposed on him by the law, and is not assumed by him under the contract. So the rule in Hadley v Baxendale cannot be explained as existing to give effect to a defendant’s intentions at the time he entered into a contract as to what liabilities he was agreeing to assume under that contract. Instead, the rule operates to prevent the law imposing on the defendant a liability to compensate the claimant for a loss that the defendant did not take the risk that the law might hold him liable to compensate the claimant for that loss when he contracted with the claimant. Any suggestion to the contrary in Lord Hoffmann’s judgment in The Achilleas is to be regretted.

(Though see para [13] of his judgment, which is entirely consistent with the analysis of the basis of the rule in Hadley v Baxendale advanced here: ‘The view which the parties take of the…risks they are undertaking will determine the other terms of the contract and in particular the price paid. Anyone asked to assume a large and unpredictable risk will require some premium paid in exchange. A rule of law which imposes liability upon a party for a risk which he reasonably thought was excluded gives the other party something for nothing.’)

The fact that Lord Hoffmann adopted an unworkable theory of the basis of contractual liability in The Achilleas should not lead us to think that his refusal simply to give effect to the letter of the rule in Hadley v Baxendale in The Achilleas was a mistake. As we have seen, the letter and the spirit of the rule in Hadley v Baxendale can diverge and in such a situation, a case can be made for adhering to the spirit rather than the letter of the rule.