Contract Breach Lawsuits and Alternatives

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1 CONTRACTS 1. Economic Functions Production takes time and a contract simply binds performance to compensation. Libertarian Justification people should be free to enter into private agreements that have no externalities By definition, contracts are Pareto superior moves in that both parties should be better off. Moral implications of contract Oliver Wendall Holmes: 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. 2. The distinction between torts and contract breach: Both result in damages Avoidance of damages in tort cases usually involve high transactions costs Avoidance of damages in contract breach cases involve low transactions costs causes of breach and damages are foreseeable and generally known.

2 3. First principle of contract adjudication: CONTRACTS SHOULD BE ENFORCED IN ACCORDANCE WITH THEIR ORIGINAL TERMS Potential causes of breach are foreseeable and remedies can be fashioned at the time the contract is negotiated. Methods of resolving unforeseeable breach can be specified (arbitration of disputes, e.g.) For a contract to exist four conditions must be met: 1) An offer 2) Acceptance of the offer 3) Performance 4) Consideration There must be a meeting of the minds of parties to a contract. 4. Second principle of contract adjudication: All the reasons that contracts should not be enforced: 1) Fraud 2) Duress 3) Incompetency 4) Gratuitous promises 5) Unconscionability

3 5. Most cases of contract breach are the result of strategic rent-seeking behavior. Contract breach Three case examples: 1. The due-on-sale controversy Tucker v. Lassen Savings and Loan 2. Trident Center v. Connecticut General Life Insurance 3. MK Gold v. MK Breach usually is the result of one or both parties engaging in opportunistic behavior RENT SEEKING 1. The due-on-sale controversy Tucker v. Lassen Savings and Loan Background late 1970 s inflationary pressures had raised interest rates significantly Prime rates were in the high teens Mortgage rates were in the low teens so that houses that sold in the early 1970 s had mortgage rates in the 5% - 7% range while banks wanted 10% - 13% for new mortgages.

4 Causes for acceleration of a mortgage contract, i.e., foreclosure o Failure to pay as agreed o waste of the property lenders look at a loan to value ratio o Sale of the property generally at the option of the lender A big issue in the sale or purchase of a home in the late 1970 s and early 1980 s was whether or not the mortgage loan on the property was assumable i.e., could the buyer pay the seller the difference between the sales price and the amount due on the mortgage and then continue paying the lender without getting a new mortgage. Under normal circumstances, i.e., stable interest rates, loans were assumable as long as the buyer met the same test of creditworthiness as the seller. A property with a 5% assumable loan was worth more than the same property with a 10% mortgage the payments were $100 s less per month. (At 5% on a 30 yr. loan for $200k the monthly payment is $1,308, at 10% the payment is $1,828.) The economic issue was who the seller or the mortgage holder should be allowed to benefit from the rise in interest rates? The capitalized

5 value of the lower monthly payment was an economic rent. The PV of $6k per year for 30 years is the economic rent that s $92k at 5% or $57k at 10%. o Sellers could capitalize the rent in the form of a higher sales price, or o Lenders could capitalize the rent by accelerating the existing loan and making a new loan at a higher rate of interest. Janet Tucker wanted to sell her house and had a buyer. Tucker and the buyer assumed the mortgage was assumable. Lassen Savings and Loan (LSL) refused to allow the buyer to assume the loan. The buyer withdrew the offer and counter offered with a lower price. Tucker sued LSL. But for what? Was there fraud? No, the mortgage contract clearly said the mortgage was due on sale. Was there duress? No, nobody forced Tucker to sign the agreement. Was Janet Tucker incompetent? No. Was it a gratuitous promise? No, both sides of the lending agreement got the benefit of their bargain. So, the contract must have been unconscionable because lenders have more bargaining power than borrowers. Lenders also understand capital markets,

6 interest rates, contracts, etc., much better than borrowers. Etc. What happened? The court found in favor of Tucker. Legal side point Since the court of decision was a California District Court, due on sale clauses in mortgages were only unconscionable in that jurisdiction and only for state chartered banks. Federally chartered banks were unaffected. What happened next? 1) LSL appealed to the California Court of Appeals and if LSL lost there it would have been appealed to the California Supreme Court, and if they lost there, due on sale clauses would be unconscionable in all California chartered banks. 2) California mortgage lenders started applying for federal charters to get protection from the Tucker ruling. 3) Due on sale clauses in mortgage contracts were challenged in federal courts, ultimately reaching the US Supreme Court which ruled that Due on sale clauses are not unconscionable. 4) End of story. 2. Trident Center v. Connecticut General Life Insurance

7 Factual Background Two large LA law firms form a LLC (Trident) to obtain financing to construct an office building in LA in 1984 They get financing from Connecticut General Life Insurance The terms of the loan were 12 ½% interest, no prepayment for 12 years, and a 10% prepayment penalty thereafter. In the late 1980 s early 1990 s interest rates fell sharply. Trident approached Connecticut General about refinancing the loan. Connecticut General said NO. Trident sued Connecticut General to get out of the contract using memoranda exchanged before the contract was signed proposing that the loan could be prepaid. The judge cited the parole evidence rule and ruled against Trident, assessing a $56k fine and required Trident to pay Connecticut General s legal expenses. The court claimed that it was absurd for a bunch of lawyers to claim that they didn t understand the contract. Trident appealed and WON the appeals court ruled that after 30 years of judicial activism in California, no claim was too absurd to win. (See Tucker vs. LSL)

8 The case went back to the original court where Connecticut General won again. Trident gave up. 3. MK GOLD V. MK Background Morrison Knudson (MK) was a large diversified construction company based in Boise, ID. Its main competitors were Bechtel, Knight- Pieshold, and other large worldwide contract construction companies. MK gained fame constructing airfields in the S. Pacific for the US Army in WWII. Like many companies in the late 70 s and 80 s MK began diversifying, creating subsidiary corporations wholly or at least majority owned by MK. One subsidiary was MK GOLD which was formed in the 80 s to take advantage of the growth in gold mining around the world. MK Gold designed and constructed mining facilities and engaged in contract mining for payment and/or equity in projects. During the early 90 s MK Gold did well but MK was going downhill. To raise cash MK did an IPO in 1995 and sold 49.4% of MK Gold to the public. The IPO contract included an Agreement Not To Compete (ANC) that prohibited MK from competing in the market for mine design, construction and contract mining services.

9 Legal side point on ANC s Common in employment and other contracts such as IPO s. ANC s must serve a legitimate business interest of the party making the offer, i.e., not simply limiting competition. The usual legitimate business interests include intellectual property rights to patents, processes, clients, etc. ANC s are limited in time and scope. In MK s case the ANC was for 10 years and worldwide. Meanwhile MK s financial condition is worsening and in 1996 they decide to sell their 50.6% stake in MK Gold. (MK was reportedly 1 mo. away from not making payroll payments.) MK finds a buyer in Leucadia National Corp. (LNC), a privately held company based in Utah. LNC does due diligence in one week (!!) and offers $26 million. MK takes it. AFTER the deal is done, MK is still in trouble and wants to bid on contracts to engage in mine design and engineering. MK contacts MK Gold and asks if MK Gold considers the ANC valid. MK Gold says yes. MK says *(^%&* you and submits bids on RFP s on several projects.

10 MK Gold sues MK for breach of contract, specifically regarding the ANC. MK Gold claims MK is hurting its business by competing with it on bids. MK hires your humble professor as an expert witness and I prepare and expert opinion with two major points: 1. MK Gold s business was lousy because the whole gold mining industry was in the tank (graphs with gold prices, stock prices, etc. were included). It had nothing to do with competition from MK. 2. The ANC did not serve a legitimate business interest of MK Gold and was therefore invalid. Deposition main focus was on the ANC. Q: Wasn t MK Gold s business hurt by MK s competition? A: Yes, but not materially and, more to the point, an ANC between MK and MK Gold would be an illegal restraint of trade similar to an ANC between Ford and GMC. The MK/MK Gold ANC does not serve a legitimate business interest. Q: Did the MK/MK Gold ANC ever serve a legitimate business interest? A: Yes, when MK owned 50+% it could have found the mother of all gold mines and kept it for itself

11 thereby depriving MK Gold shareholders of the benefit of their ownership of MK Gold. Q: Why can t MK do that now? A: Because MK doesn t own MK Gold anymore! AFTERMATH MK Gold filed another lawsuit for breach claiming fraud. (I thought they would have had a better chance claiming their own incompetence.) MK files for bankruptcy MK Gold petitions the bankruptcy court claiming MK defrauded them. MK is taken over by Washington Construction Corp. MK Gold sues them. Washington Intl. Corp. files for bankruptcy. MK Gold petitions the bankruptcy court claiming MK/Washington defrauded them. Washington eventually comes out of bankruptcy and MK Gold is offered 12.5% of Washington to settle its claims. The lawyers made a lot of money.