ERISA Wants Your Claim to be Denied – Part I

Breaching a contract seems to most people like a bad thing to do – after all, when you get right down to it a contract involves mutual promises: you pay me this much money, and I’ll do something for you in return. Breaching the contract, then, means breaking a promise. So breaching a contract is wrong, isn’t it?

Well as far as the law is concerned, the answer to that is “it depends.” There’s a theory, known among other things as the theory of “efficient breach,” which holds that not only is it not always wrong to breach a contract but that sometimes it’s the right thing to do; the law ought to encourage breaches of contracts where it is appropriate to do so; and on analysis it does.

The theory goes something like this. One: the law will not (and ought not) “punish” you for breaching a contract, it will only make sure that you fully compensate the other party if you do. Two: if it turns out that it would be more profitable for you to breach the contract and make the other party whole, then it is more economically efficient, and therefore a good thing, for you to go ahead and breach the contract.

A leading proponent of this theory is Judge Richard A. Posner of the Seventh Circuit Court of Appeals. In his book “Economic Analysis of Law,” Judge Posner gives the following example:

I sign a contract to deliver 100,000 custom-ground widgets at $.10 apiece to A, for use in his boiler factory. After I have delivered 10,000, B comes to me, explains that he desperately needs 25,000 custom-ground widgets at once since otherwise he will be forced to close his pianola factory at great cost, and offers me $.15 apiece for 25,000 widgets. I sell him the widgets and as a result do not complete timely delivery to A, who sustains $1000 in damages from my breach. Having obtained an additional profit of $1250 on the sale to B, I am better off even after reimbursing A for his loss. Society is also better off. Since B was willing to pay me $.15 per widget, it must mean that each widget was worth at least $.15 to him. But it was worth only $.14 to A – $.10, what he paid, plus $.04 ($1000 divided by 25,000), his expected profit. Thus the breach resulted in a transfer of the 25,000 widgets from a lower valued to a higher valued use.

OK, so here Judge Poser breached his contract with A, and everyone involved came out at least as well as if Judge Posner had performed. A still realized his expected $1000 profit, because Judge Posner had to compensate him in that amount as damages for his breach of contract. B is better off because he ended up with the widgets, and based on the price he was willing to pay for them he needed them more than A did –they were more valuable to him than they were to A. And Judge Posner came out $250 ahead (his $1250 profit on the deal with B less the $1000 he had to pay to A) because of B’s willingness to pay a higher price. And finally, according to economic theory, society is better off whenever an asset is dedicated to a more valuable use, which is the case here as measured by B’s willingness to pay more than A was.

Later this week we will explore how these concepts are turned on their head when it comes to a breach of an insurance contract by an ERISA insurer. For now remember the essence of an “efficient breach”: the breaching party makes a rational decision to breach a contract because even accounting for the liability it will incur by virtue of the breach, including the obligation to make the other party whole, the breaching party still comes out ahead.