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EMBEDDED OPTIONS AND THE CASE AGAINST COMPENSATION
IN CONTRACT LAW
Robert E. Scott*
George G. Triantis**
Compensation is the governing principle in contract law remedies. The principle shapes the doctrines that
specify the consequences of breach: particularly the default provision for expectation damages and the
restriction on the parties’ ability to stipulate damages. Yet, the compensation principle has tenuous
historical, economic and empirical support. Moreover, a promisor’s right to breach is a subset of a family
of termination rights that serve important risk management functions. The termination rights, in turn, can
be characterized as call options on the subject matter of the contract. Where a buyer can terminate her
obligation to purchase a good, she effectively holds a call option defined by its option price and exercise
price. The option price is the buyer’s sunk investment, which may be in the form of the prospective
damages liability under the contract, and the exercise price is the additional sum needed to acquire the
good. The contracting choice among the many pairs of option price and exercise price is subject to a
variety of factors identified in this essay. In light of the heterogeneity among optimal option prices, we
argue not only against the penalty rule restriction on liquidated damages, but also against having even a
default damages provision to begin with. We propose that parties be forced to agree explicitly with
respect to all termination rights, including breach damages, either by the threat of specific performance of
their contemplated exchange or by the court’s refusal to enforce contracts that fail to do so.
Compensation is the governing principle in contract law remedies. This principle shapes the
key doctrines that specify the consequences of breach. Expectation damages, the default measure of
damages, aim to put the promisee in the position she would have occupied had the promisor performed,
while specific performance is available at the option of the promisee when the court believes that money
damages are inadequate to compensate for her loss. Although parties may agree to liquidated
David and Mary Harrison Distinguished Professor of Law, University of Virginia
Perre Bowen Professor of Law and Horace W. Goldsmith Research Professor, University of Virginia
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damages, contract doctrine instructs them to abide by the compensation norm. We argue in this article
that, although the compensation principle has a profound influence on contemporary contract law
doctrine, it has tenuous historical, economic and empirical support. Its evolution in the common law
was more accidental than deliberate; compensation is virtually ignored in the theoretical analysis of
efficient contract design and it plays little role in the contracts expressly negotiated by commercial
parties and by consumers. As a result of an unfortunate turn in history, contract damages are
analogized to compensation for wrongs, and this has impeded the efficient evolution of both default
remedies and the regulation of liquidated damages.
It is well known that contract damages effectively give the promisor an option between
performing the promise or breaching and paying damages.1 Over the past decade, legal scholars have
begun to analyze contract remedies explicitly in terms of options.2 But contract damages are only a
subset of the broader category of termination rights that give one party an option to walk away from the
contemplated exchange.3 A firm offer or unilateral promise, for example, grants the promisee such an
option. Broad warranties, such as satisfaction-or-your-money-back provisions, give buyers similar
The classic statement is by Oliver Wendell Holmes:
Nowhere is the confusion between legal and moral ideas more manifest than in the law of contract. Among
other things, here again the so called primary rights and duties are invested with a mystic significance
beyond what can be assigned and explained. The duty to keep a contract at common law mean a prediction
that you must pay damages if you do not keep it–and nothing else.
Oliver Wendell Holmes, The Path of the Law, 10 Harv. L. Rev. 457, 462 (1897).
Robert E. Scott, The Case for Market Damages: Revisiting the Lost Profits Puzzle, 57U. Chi. L. Rev. 1155
(1990); George G. Triantis, The Effects of Insolvency and Bankruptcy on Contract Performance and Adjustment, 43
Univ. Tor. L. J. 679; Alexander J. Triantis and George G. Triantis, Timing Problems in Contract Breach Decisions, 41
J. Law & Econ. 163 (1998); Paul G. Mahoney, Contract Remedies and Options Pricing, 24 J. Legal Stud. 139 (1995);
Victor P. Goldberg, The Net Profits Puzzle, 97 Colum. L. Rev. 524 (1997); Victor P. Goldberg, Discretion in Long-Term
Open Quantity Contracts: Reining in Good Faith, 35 U.C. Davis L. Rev. 319 (2002); Avery Wiener Katz, The
Efficient Design of Option Contracts: Principles and Applications, (mimeo 2004).
See TAN infra.
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options. Requirements, output or installment contracts grant one party substantial discretion to
determine the contract quantity. And a contract may provide that one party has the right to terminate,
to cancel, to renew, or to return or redeem goods.
Either or both parties to a contract typically enjoy the right to terminate at some cost. For the
purposes of our analysis and argument, we focus on the option held by a buyer of goods or services.
The buyer holding an option has the right to avoid the exchange by paying either a termination fee or
damages. Several previous articles characterize the right to breach as if the buyer held a put option on
the agreed upon exchange that she could exercise by paying damages to the seller.4 In this essay,
however, we analyze the buyer as effectively incurring an obligation to pay damages in exchange for a
call option on the subject matter of the contract. The exercise price of the option is the difference
between the contract price and the damages liability. The buyer’s prospective liability for damages is
effectively the price of the call option (the option price), as if the buyer makes a nonrefundable deposit
or payment for the call option and pays an additional price to exercise it. The option price is a function
of the exercise price: the higher the exercise price, the less valuable the call option and, generally, the
lower the option price. We label the exercise price of the buyer’s call option, x, and the option price,
d (to remind the reader of the link with damages), and we describe the option created by the
termination provision by the pair (d,x).
The price of an embedded call option is determined just as the price of any other product: it is a
function of the option’s value to the option holder, the cost to the option writer and the competitiveness
By exercising the put, the buyer, in effect, sells the contract good or service back to the seller for the
stipulated damages liability. Triantis, Effects of Insolvency and Bankruptcy, supra note –, at 680-4; Mahoney, supra
note –; Triantis and Triantis, supra note –, at 168-9, 169 n15.
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of the market in which they transact. In light of the great variety in the conditions under which parties
contract for this option, it should not be surprising that commercial and consumer contracts contain a
wide range of call option prices. These prices are rarely equivalent to the measure of the seller’s
expectation in a completed sale.
Consider the electronics store that sells television sets for $400 and offers full refunds for any
returns made within 30 days. This contract gives the buyer a free 30-day call option to purchase the
television set for $400. Recall that we characterize the right of termination as a call option described by
the pair of an option price and exercise price, (d, x), where the contract price is P = d + x. This
contract’s pairing of option price and exercise price is (0,400). The option is valuable to the buyer
because she is uncertain as to the value of the television set to her family. The retailer in this case bears
significant costs in accepting returns, including the cost of receiving, inspecting and reselling the returned
goods, often through a discount outlet or internet sale. Nevertheless, options to return without charge
are frequently given to buyers for free. Such “free” options are remarkably common in both
commercial and consumer contracts.5 They are particularly interesting for our purposes because these
contracts make no attempt to compensate the seller for losses it suffers when the buyer walks away
from the contemplated exchange. These return options provide free insurance to buyers, which is
puzzling at first blush because of the adverse selection and moral hazard problems they are likely to
create. But buyers do pay an exercise price in the cost of bringing the product back to the store. If the
It is inaccurate to conclude that the cost of the option is included in the overall contract price because the
buyer does not pay this price if she walks away from the option. Where the seller does not charge the buyer for an
unexercised option, the seller recovers the cost from buyers who exercise the option. This cross-subsidization leads
to adverse selection and moral hazard issues discussed later in the paper. Another example of a free option is the
right of consumer borrowers to prepay their loans or mortgages without compensating their lenders for
consequential losses that might be caused, for example, by declines in the market rate of interest. Similarly, a
borrower who defaults is liable to pay the accelerated balance owing, but not compensation for the lender’s foregone
opportunities when market rates have dropped since the loan.
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consumer would pay up to $25 to avoid the trip, we might characterize the return option as (25, 400),
even though the $25 is not payable to the store.6
Some buyers enjoy no call option because they pay (or owe) the entire purchase price and
cannot escape this obligation by cancelling the transaction.7 Some retailers, for example, offer refunds
for ordinary course sales but do not accept returns of sale merchandise. Although sale merchandise
may be more difficult to resell, it is likely that the retailed is “undercompensated” in the former case and
“overcompensated” in the latter. Additional examples of overcompensation can be found in the
penalties consumers pay in other transactions. For example, economy fares on airlines are typically
conditioned on a penalty of $100 if the passenger chooses to not travel or to change her itinerary: if the
fare is $250, the passenger’s call option is (100, 150).8 The penalty applies even on flights that are
overbooked and almost certain to be full.
Indeed, our casual observation reveals that the termination provisions affecting consumers
regularly departs from the predictions of the compensation principle. Examples of such embedded
options abound in commercial contracting as well. Retailers often have the right to return unsold
If we think briefly about the seller’s option, we note that liquidated damages are often pegged significantly
below the compensatory level. For example, repair and replacement are common remedies for defective performance.
Contracts also limit recovery for packages lost by couriers or luggage lost by airlines. Recently, distributors of
electricity have issued interruptible electricity contracts that allow the distributor some flexibility to interrupt electric
service to commercial customers, which they exercise in times of demand spikes. Some contracts provide for
financial compensation at the time of the interruption, but others provide for a payment in advance. Neither payment
is intended to reflect the loss suffered by the customer. See Ross Baldick, Sergey Kolos and Stathis Tompaidis,
Valuation and Optimal Interruption for Interruptible Electricity Contracts (Univ. of Texas Working Paper 2003).
Of course, fresh start in bankruptcy (and limited liability of some organizations) creates the well known
option held by debtors, which we set aside in this essay.
Indeed, in the event of a change in plans, the passenger also may have to pay any increase in the fare
from the time she bought the ticket.
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merchandise to the wholesaler or distributer. Rights of return are common, for example, in the retailing
of books, journals, newspapers, musical compact discs, jewelry, and cigarettes.9 Aircraft
manufacturers permit purchasers to cancel orders or to change the type of aircraft even after the
manufacturer has made significant investment in production.10
Why are these contracting patterns so much at odds with the compensation principle that
governs contract law? In this article, we offer the explanation based on the risk management objectives
of many contracting parties. It is well known that compensatory remedies insure the buyer against the
seller’s breach and thereby against the risk of fluctuations in the seller’s cost of performance.
Options created by termination rights provide another type of insurance that benefits risk averse buyers
and contributes to the risk management objectives of business contractors.11 The ability of a buyer to
breach and pay expectation damages partially insures the buyer against decreases in the value of the
seller’s performance. The buyer can avoid the loss to the extent that it is greater than the seller’s
Eugene Kandel, The Right to Return, 39 J. L. & Econ. 329, 330 (1996).
For example, Airbus allows buyers to choose between the aircraft in its family of A318, A319, A320 and
A321 with a very short lead-time. These aircraft are built on the same production line and have many common
components, so the decision as to which aircraft is built can be delayed. Airbus explicitly markets contract options
and offers guidance to buyers in the valuation of these terms. John Stonier and Alexander J. Triantis, Natural and
Contractual Real Options: The Case of Aircraft Delivery Options, in A. Micalizzi and L. Trigeorgis, eds., Real
Options Applications 159-195 (1999). John Stonier, The Change Process, in Tom Copeland and Vladimir Antikarov,
Real Options: A Practitioner’s Guide 47 (2001).
In his Nobel lecture, Robert Merton stated: “When [an option is] purchased in conjunction with
ownership of the underlying asset, it is functionally equivalent to an insurance policy that protects its owner against
economic loss from a decline in the asset’s value below the exercise price for any reason.” Robert C. Merton,
Applications of Option-Pricing Theory: Twenty Five Years Later, 88 Am Econ. Rev. 323, 336-7 (1998). In Merton’s
terms, the buyer in a contract “owns” the contract and holds a put on that asset. Although framing the termination
right as insurance (or a put option) may fit better with the conventional language of contract theory, we prefer to
speak of the equivalent call option (equivalent by virtue of put-call parity).
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expected profit under the contract.12 But if the buyer has the right to cancel and pay less than the
seller’s expectation, then the seller effectively insures the buyer against more severe decreases in the
value of the exchange to the buyer. This insurance is efficient if the seller enjoys a comparative
advantage in bearing the risk by hedging or diversifying against it. The seller’s actions in performing the
underlying contract itself might also reduce the variance in valuation. Through such contract options,
therefore, buyers can manage some of the risks of their operations by outsourcing risk management to
Most contract scholars appreciate that remedial provisions affect contract price: the higher the
prospective damages liability, the less the buyer is willing to pay in the contract. The options analysis,
however, frames the determination somewhat differently. The damages liability is the price of a call
option and it depends on the exercise price of the option. For any given exercise price, the option price
divides between the parties the surplus created by the option: namely, the difference between the
option’s value to the buyer and its cost to the seller. The parties should choose a pairing of option price
and exercise price that maximizes this surplus. Given the close link between options and insurance, it
should not be surprising that the optimal terms of embedded options are a function of considerations
that determine insurance contracts: risk bearing capacity, adverse selection and moral hazard. Although
we discuss the role of these considerations in the structuring of embedded options, our principal
contribution is to highlight the heterogeneity of optimal terms, which is consistent with our observation of
a wide variety of termination provisions in practice.
As explained in Part II, this insurance against downside risk is a product of the abandonment option
created by nature. Termination rights in a contract allocate between the parties the abandonment option that an
integrated firm would enjoy in any venture. Compensatory damages promote the optimal abandonment of the
parties’ joint venture (what is conventionally known as efficient breach).
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This diversity has important normative implications for the default rules of contract damages.
The characterization of breach damages as an option price separates damages from the compensation
principle and reinforces the criticisms of the penalty rule that have been raised by contract scholars.13
A theory of embedded options suggests that, in many contexts, a default rule may be no more
appropriate with respect to damages than with respect to the price of any other good, service or
contract term for which there is no established market price. In thick markets, courts should simply
enforce the risk allocation specified in the contract by awarding market damages. Outside thick
markets, we argue in favor of a bargain-forcing approach of judicial restraint. The courts could refuse
to recognize any option by specifically enforcing the contract exchange unless the parties clearly state
the price and exercise price of the option. Or, the courts might refuse to enforce the contract as a
whole if it fails to make express provision regarding termination rights.
The article proceeds as follows. In Part I, we contrast the contemporary dominance of the
compensation principle of contract damages against its tenuous historical roots, its marginal relevance in
contract economics and its limited use in commercial and consumer contracts. Part II characterizes the
termination provisions available to a buyer – including the right to breach and pay damages -- as call
options that serve an important risk management function. We specify factors that explain the variations
in the price paid for these options. Part III draws the implications for optimal default rules for breach of
contract summarized above. The Conclusion summarizes and proposes an agenda for future research.
See TAN infra. The compensation principle is also responsible for leading courts as well as scholars to
search in the wrong place for solutions to lost-volume seller cases by debating alternative measures of the seller’s
loss. See Scott, The Case for Market Damages, supra note – .
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I. RECONSIDERING THE COMPENSATION PRINCIPLE IN CONTRACT LAW
A. The Dominance of the Compensation Principle in Contract Law Doctrine
The doctrinal view of contract breach is that it is a wrong that is remedied by compensating the
victim for her loss.14 This view is reflected in the default provision for damages and the constraints
imposed on the freedom of parties to stipulate other measures of damages by contract. The
Restatement of Contracts, for example, states that “[t]he traditional goal of the law of contract remedies
has not been compulsion of the promisor to perform his promise but compensation of the promisee for
the loss resulting from breach.”15 Since the classic article by Fuller and Perdue in 1936, courts and
scholars have typically compared three alternative bases for evaluating the promisee’s entitlement to
compensation: restitution, reliance and expectation.16 The dominant measure is expectation damages:
See, e.g. Uniform Commercial Code § 1-106: “The remedies provided by this Act shall be liberally
administered to the end that the aggrieved party may be put in as good a position as if the other party had fully
performed...”; Restatement(Second) of Contracts §347. Although the compensation principle is firmly enshrined in
the Code and the Restatement, we suggest in the next section that contract law embraced the compensation principle
relatively late in its common law development.
Restatement (Second) of Contracts, Intro. Note to Ch. 16, Remedies. See also, E. Allan Farnsworth, Legal
Remedies for Breach of Contract, 70 Colum. L. Rev. 1145, 47 (1970) (describing the common view that the central
purpose of contract damages is compensation); UCC § 1-106, Comment 1 (same). For Oliver Wendell Holmes, at
least, the task of determining the proper remedies for breach is simply the gap filling analysis courts use to allocate
other contractual risks . See, for example, the following from Globe v. Landa, Cotton Oil Co., 190 U.S. 540 (1903):
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. It is
true that, as people when contracting contemplate performance, not breach, they commonly say little or
nothing as to what shall happen in the latter event, and the common rules have been worked out by
common sense, which has established what the parties probably would have said if they had spoken
about the matter. (Emphasis added).
Lon L. Fuller and William R. Perdue, Jr., The Reliance Interest in Contract Damages:1, 46 Yale L.J. 52
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the payment necessary to put the promisee in as good a position as if the promisor had performed.17
Over the past 150 years, the courts have expanded the availability of compensation for the promisee’s
consequential losses, subject only to relatively modest constraints of mitigation, foreseeability and
uncertainty.18 Specific performance is available at the option of the promisee when money damages are
thought inadequate to compensate for her loss.19
The dominance of the compensation principle explains the legal regulation of parties’ ability to
stipulate damages expressly in their contract. Although most of contract law provides default rules from
which parties are free to contract away, remedial defaults carry heavier presumptive weight than other
provisions. Contract breach terms may not deviate from the compensation principle. According to
doctrinal statements, the only permissible ground for stipulating damages is the anticipated difficulty of
measuring the promisee’s loss. For instance, the UCC provides that stipulated damages must be an
amount that is reasonable in light of the anticipated or actual loss caused by the breach and the
difficulties of proving the amount of loss.20 In practice, the courts strike down supercompensatory
Restatement (Second) of Contracts §344, 347. “The initial assumption is that the injured party is entitled
to full compensation for his actual loss.” Intro. Note to Topic 2, Enforcement by Award of Damages.
In a recent article, Richard Craswell observes that courts appear willing to soften or disregard these
traditional limitations when they find that the breach was willful. Richard Craswell, Against Fuller and Perdue, 67 U.
Chi. L. Rev. 99, 138-43 (2000). Craswell cites Arthur Corbin as noting that “a lesser degree of certainty will be
required as against one whose breach is described as ‘willful’ or is motivated by malice or avarice than against one
whose breach was due to misfortune and whose efforts to perform were honest and in good faith.” Id. at 140.
Craswell also speculates that courts may choose reliance damages as means of effecting some sharing of losses
between contracting partners (for example, in response to an unforeseen contingency).
Restatement (Second) of Contracts §359. See ROBERT E. SCOTT & JODY S. KRAUS , CONTRACT LAW AND
T HEORY 116-118, 992-95 (3D. ED. 2003).
UCC § 2-718; Restatement (Second) of Contracts §356 (same). The modern penalty rule found in the
Code and the Restatement is derived from a line of common law cases invalidating any stipulated damages where the
amount specified exceeded the “just compensation for the loss or injury actually sustained.” Jaquith v. Hudson, 5
Mich. 123, 133 (1858). For discussion, see Charles J. Goetz & Robert E. Scott, Liquidated Damages, Penalties and
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liquidated damages far more often than they police undercompensatory limitations on damages.21 In
cases in which it is especially difficult to measure the promisee’s loss, a court may order specific
performance or an injunction even in the face of a contractual provision for liquidated damages.22 This
additional basis for setting aside liquidated damages provides further evidence that the law regards
measurement difficulty as the sole legitimate reason for deviating from the default of expectation
B. Historical Roots of Compensation in Contract Breach Remedies
Although now firmly entrenched in doctrine, the compensation principle is a recent development
in contract law. As we describe in some detail below, the courts did not demonstrate a strong
inclination to compensate the promisee for the losses caused by the promisor’s breach and they
enforced the parties’ agreement respecting the consequences of breach until the 19th Century.
Therefore, our critique of the compensation principle does not attack a deep-rooted principle of
the Just Compensation Principle, 77 Colum. L. Rev. 554, 555-557 (1977). Restatement (Second) of Contracts § 347,
Comment a states that “The parties to a contract may effectively provide in advance the damages that are to be
payable in the event of breach as long as the provision does not disregard the principle of compensation.” UCC § 2-
718, Comment 1 states: “A term fixing unreasonably large liquidated damages is expressly made void as a penalty.
An unreasonably small amount would be subject to similar criticism and might be stricken under the section on
unconscionable contracts or clauses.”
See e.g., 5 ARTHUR CORBIN, CONTRACTS, § 1068 (1964) (“public policy may forbid the enforcement of
penalties against a defendant, but it does not forbid the enforcement of a limitation in his favor.”); Justin Sweet,
Underliquidated Damages As Limitations of Flexibility, 33 Tex. L. Rev. 196, 203-06 (1954). Although we would
expect that undercompensatory liquidated damages are in fact at least as common as overcompensatory provisions,
a review of reported cases between 1998 and 2003 reveals that the incidence with which courts strike down penalties
far exceeds their rejection of undercompensatory damages provisions. [summarize results here]
Restatement (Second) of Contracts § 361, Comment a states:
Merely by providing for liquidated damages, the parties are not taken to have fixed a price to be paid for the
privilege not to perform. The same uncertainty as to the loss caused that argues for the enforceability of
the provision may also argue for the inadequacy of the remedy that it provides.(emphasis added)”
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1. Forms of Action under the Early English Law of Contract: The Evolution of the
At early common law, there was no cause of action for breach of an informal (unsealed)
executory promise.23 The only actions available for breach of contract were the action for debt and the
action in covenant (for instruments under seal). The notion of compensation was foreign to either
action. The action for debt lay only for the recovery of a sum certain. One party was seeking relief for
a debt that was due and owing, fixed by the parties prior agreement, and the court in no sense awarded
compensation for breach of contract. For example, where a seller tendered goods to a buyer and the
buyer refused to accept delivery, the seller was able to recover the purchase price and force the buyer
to take delivery of the goods (for which title had passed under the contract).24 Alternatively, if the
buyer tendered the purchase price and the seller refused to transfer goods that were then available, the
buyer had no action at law. Here, the buyer’s only recourse was to bring an action in equity for specific
performance since the remedy at law was inadequate.
The evolution of commercial exchange during the late middle ages increased the pressure on
the legal system to supplement the self-enforcement mechanisms of the law merchant and medieval
trade fairs with a legal mechanism that permitted promisors to make credible promises to strangers.25
The response of the English common law courts was to recognize a promisee’s right to recover in
assumpsit for breach of promise. Assumpsit was originally a tort action (“he undertook”) that
JAMES BARR AMES , LECTURES ON LEGAL HISTORY 92 (1913); Id. at 92, 122-23; A. W. B. SIMPSON, A
HISTORY OF THE COMMON LAW OF CONTRACT 47-48 (1986).
AMES , LECTURES ON LEGAL HISTORY at 88-89.
Avner Grief, Informal Contract Enforcement: Lessons from Medieval Trade in 2 THE NEW PALGRAVE
DICTIONARY OF ECONOMICS AND LAW 287 (Peter Newman, ed. 1998).
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developed in response to the need to provide an action in tort for the negligence of a bailee or carrier
The principle of compensation that supported the action in assumpsit was thus a distinctly tort
notion premised on the idea of ex post redress for a harm committed by the defendant.27 Over time the
action in assumpsit was seen as an attractive avenue for seeking recovery for promissory undertakings.
Initially, a plaintiff was allowed to bring assumpsit only where the defendant performed his promise
unskillfully (i.e., a carpenter who undertook to build a house for the plaintiff and performed poorly).
Subsequently, the English courts held that a plaintiff could recover in assumpsit for the promisor’s
failure to act altogether. In such a case, the plaintiff could recover damages based upon the principle of
compensation for the injury done (in this case the nonperformance of a promise to act).28 The
action in assumpsit for breach of promise thus lay for plaintiffs who had either conferred benefits and or
undertaken action in preparation for performance in reliance on the defendant’s promise. In either
case, a plaintiff who was seeking compensation via assumpsit was asking for compensation under a
theory of reimbursement for the loss of that which had been given (directly or indirectly) to the
SIMPSON, supra note — at 210-215. The traditional tort action of trespass on the case would not permit
recovery for negligent bailment because the plaintiff could have been equally careless in entrusting a third party with
his property. Id. In the Humber Ferryman Case, for example, the plaintiff alleged that defendant bailee undertook to
carry his goods safely. The failure to perform this undertaking was the gravamen of the action, and, as was
traditional in tort actions, the resulting injury to the plaintiff’s property required compensation. 22 Lib. Ass., Edw.
III pl.41 (1348).
AMES , SUPRA NOTE -- at 130. A parallel line of cases permitted recovery in deceit for a false warranty for
goods sold and delivered. This action was also, in its origin, a pure action in tort. Id. At 136-7.
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2.. The Enforcement of Executory Promises: Compensation as Market Damages.
The final stage of the development of assumpsit was the recognition of the enforceability of a
purely executory exchange of promises. For many years, the orthodox view among legal historians had
been that this final stage of development matured in England sometime in the 16th or 17th centuries. But
Morton Horwitz has argued convincingly that the enforceability of executory contracts occurred much
later, at the end of the 18th century (in England) and the beginning of the 19th century (in America). This
development coincided with a period of commercial expansion and with the development of markets
for the sale of commodities and subsequently for the sale of stock.30
As late as the 18th century, therefore, contract law was still dominated by the action in debt and
a title theory of exchange. Recovery was based on the price of goods tendered or delivered (or, in the
case of a breach by the seller, an action for specific performance in equity). Throughout the 18th
century, exchange was not conceived in terms of future returns and thus expectation damages were not
recognized by 18th century courts on either side of the Atlantic.31
During this early period of the action in assumpsit, a plaintiff could bring an action for breach of promise
independent of the doctrine of consideration and the concept of exchange. The early notion of special assumpsit
(the contract action) did not require a quid pro quo as was required for an action for debt which was explicitly tied to
the notion of exchange. AMES , supra note – at 143-144.
Morton Horwitz, The Historical Foundations of Modern Contract Law, 87 Harv. L. Rev. 917 (1974).
Horwitz cites only two English cases in the 18th century that raise the issue of expectation damages.
Horwitz, supra note – at 921. In Fleureau v. Thornhill, 96 Eng, Rep. 635 (C.P. 1776), the court limited the plaintiff to
restitution damages, holding that “plaintiff could not be entitled to damages for the fancied goodness of the bargain
which he supposes he has lost.” In the United States, only a few actions for breach of executory contracts were
brought before the Revolutions. See, e.g, Boehm v. Engle , 1 Dall. 15 (Pa. 1767) where the seller was allowed to sure
for the contract price of breach of a contract for the sale of land. Id. at 922.
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This narrow conception of contract as enforcing only partially executed exchange transactions
conceived of compensation in equally narrow terms. Chancellor Kent articulated this principle of
contract damages as compensation being fixed by the jury “with a moderation agreeable to equity and
good conscience and where the claims and pretensions of each party can be duly attended to...”32
During this pre-market period, courts almost universally declined to instruct juries on damages defaults
or to revise damage judgments (whether excessive or inadequate). During the 18th and well into the
19th centuries, therefore, common law courts enforced only partially executed transactions, and saw
the compensation principle as requiring either reimbursement or, where the promisee’s performance
was tendered, specific performance. These courts did not assure a plaintiff “the value of his bargain,”
but rather would specifically enforce the actual bargain that the parties had struck.
Executory contracts were not enforced in the United States until the decision in Sands v.
Taylor in 1810.33 Under the older rule, where a buyer breached a contract to purchase goods, the
seller would have been required to tender the contract goods and sue for the contract price. But in this
case, the seller covered on the market by reselling the goods to a third party and then sought damages
based upon the contract-market differential. The court conceded that this was a case of first
impression in America and granted the plaintiff market damages.34 The subsequent emergence of a
market damages default rule coincided with the increased use of fixed- price forward contracts for the
delivery of commodities.35 Disputes over stock transactions were also common during this period;
Seymour v. Delancy, 6 Johns. Ch. 222, 232 (N.Y. Ch. 1822).
5 Johns. 395 (N.Y. 1810).
See e.g., Shepherd v. Hampton, 16
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