The John M. Olin Center

Paper Abstract

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25. Yuval Procaccia, The Precontractual Commitment as a Solution to the Holdup Problem, 9/2008.

Abstract: In the course of negotiations, parties often communicate their bargaining positions by extending commitments. Legal scholars and courts have long struggled with the question of whether such commitments ought to be legally binding although a formal contract had not yet been formed. On the one hand, denial of legal enforcement is arguably desirable, as it allows parties to pursue their negotiations freely, without fear of liability prior to ascertaining the potential for a mutually beneficial deal. Such liability is argued to create a "chilling effect" that would undesirably deter parties from entering into negotiations in the first place. On the other hand, however, denial of precontractual enforcement gives rise to the classic holdup problem when parties engage in precontractual reliance. By eroding parties’ incentives to rely, denial of enforcement diminishes the magnitude of the joint expected surplus.   
Although the adverse impact of the holdup problem is often significant and the volume of related case law is large, the existing law of precontractual commitments is highly indeterminate and substantially lacking in clarity and consistency. The purpose of this paper is to provide a systematic analysis of the merits of such enforcement. It explains how enforceable precontractual commitments could be designed to solve the holdup problem, while generating optimal reliance and trade. Furthermore, it demonstrates that enforcement of such commitments need not limit parties’ ability to remain free from unwanted liability; thus, applying a penalty for breach does not, in and of itself, undermine the incentive to negotiate.

Parties' incentives with respect to trade and reliance are a function of the measure of damages applied in cases of breach. It is shown that both measures of expectation damages and reliance damages generate optimal decisions to trade and invest. This result is partially consistent with existing doctrine, under which commitments are enforced by one of these two types of remedies. However, it is also observed that for the optimal results to obtain, parties must be able to foresee which of these measures will be applied prior to the extension of the commitment. Hence, an additional implication of the analysis is that the default rule of enforcement ought to be made more foreseeable, and that the current degree of ex post judicial discretion is overly broad.