Easy Cases Make Good Tests:

Analysis of Modern Pre-Contractual

Disclosure Theories

ולר מרצה: דר' שחר03604156-4- ת.ז. אופק מגיש: תדהר

חוזים בדיני בסוגיות מתקדם סמינר:דיון

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Chapter I: Introduction

What is the nature of the pre-contractual disclosure dilemma?

Despite over 2000 years of research, it is still unknown what factors positively determine which

information a bargaining party must voluntarily disclose to one's bargaining partner.1 The law concerning

the pre-contractual duty to disclose governs this requirement as part of the greater obligation to conduct

negotiations in good-faith. Broadly delineated in Israeli legislation via both the good-faith-in-negotiations

and deception doctrines found in the Contracts Law (General Part) and the Consumer Protection Law, the

law regarding this duty suffers from a lack of consistency on every level of analysis, at times seeming more

like an ad hoc heuristic instead of a legal rule.2

Judicial precedents, legal trends and modern academic theories all display a lack of coherency with

regards to this duty. Court decisions have not only failed to adopt a consistent rule governing disclosure, but

have commonly reached differing results in similar cases.3 In spite of a legal trend moving toward a greater

disclosure requirement with the normative departure from the caveat emptor doctrine towards “The Implied

Warranty of Fitness” doctrine and the like, the implementation of such doctrines has not resulted in an

overall increased disclosure.4

Modern theories on disclosure remain utterly conflicted as to which criteria constitute the basic

determinant of this duty, and none have withstood the test of the positive law.5 Theories which claim to

unify juridical decisions have been criticized as only matching the positive law through malleable,

indeterminate criteria; while theories based on solely normative grounds have been shown as tautological or

inconsistent on their own terms; or simply distanced from the positive law.6

However despite all of the aforementioned unpredictability and conflict there are well-established,

broadly consented to positions within the realm of pre-contractual disclosure. These “trivial” positions are

largely neglected by most theories, which instead focus on 'hard cases' in their attempt to forge a unifying

1 Krawiec, Kimberly D. and Zeiler, Kathryn, "Common Law Disclosure Duties and the Sin of Omission: Testing the Meta-theories" (November 1, 2004). Georgetown Law & Economics, p.4-5; Anthony Duggan, Michael Bryan, Frances Hanks, Contractual Non-Disclosure (Melbourne: Longman Press, 1994), p.2. Cicero's jurisprudential masterpiece, De Officis, written over 2000 years ago, discusses the boundaries of the duty to disclose. In an oft-cited passage, he distinguishes between actively concealing information and refraining from revealing it (aliud est celare, aliud tacere) – noting that not all information material to a contracting party need be disclosed. His distinction between these two circumstances seems to parallel Scheppele's distinction between 'deep' and 'shallow' secrets – discussed in Chapter III.2 Contracts Law (General Part), 5733-1973 clauses 12, 15; Consumer Protection Law, 1981; Civil Appeal 838/75 Spektor v. Tzarfati; Civil Appeal 338/85 Spiegelman v. Chapnik; Civil Appeal 9019/99 Kistlinger v. Aliya. In the Spektor case, a divergence of opinions arose between Justice Asher and Justice Landoi, the former arguing and ultimately determining a strict pre-contractual disclosure requirement via the good-faith-in-negotiations doctrine. The Spiegelman case, ten years later, determined a less stringent disclosure requirement, contending that if a party remained uninformed due to its own negligence it could not argue that the informed party failed to act in good faith or deceived it. Nearly fifteen years later, the Kistlinger case linked the deception and good-faith-in-negotiation doctrines, finding that a violation of clause 12 constituted a breach of the final section of clause 15, the passive infringement of the deception doctrine.3 Krawiec and Zeiler, p.24 Krawiec and Zeiler, p. 35 Scheppele’s theories, Kronman’s theories and those theories based on Hirshleifer’s productive efficiency argument are all criticized for failing to truly account for the positive law in a deterministic manner.6 All of the theories cited in this seminar, with perhaps the exception of Eisenberg's, are centered around distinctions which are largely ambiguous and difficult to apply.

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theory.7 A key to the disclosure puzzle may lie in the normative justification for these 'easy cases,' which

though they might seem the exception within such an irreconcilable field –are really quite common. In

hindsight, it is fitting that trivial cases would illuminate the solution to a legal problem. After all, it is well-

known that the bewitching 'hard cases', and not those stodgy 'easy ones', usually make 'bad law'.

Since nearly all modern disclosure theories are based on criteria which are recognized as

indeterminate (e.g. Scheppele’s ‘equal access’ principle, Kronman’s deliberate/casual distinction), 'easy

cases' would naturally form a better testing ground for these theories than 'hard cases,' since the answers to

the former are clear, making it obvious if a theory matches the positive law. When using a disclosure

criterion to approach a 'hard case,' it would be understandable if the criterion did not clearly provide an

answer matching the positive law – since the courts themselves do not possess an unequivocal answer to the

question.

In a ‘hard case,’ it may even be expected that a theory’s analysis fall right between the lines of

distinction; in such a case it would be comprehensible of a sound theory to unclearly determine if the

information possessed would be considered a ‘deep’ or ‘shallow’ secret, for example, or that the type of data

acquired was ‘productive’ or ‘redistributive’ in nature, to name another.

However, this would not be expected of an easy case. If a theory does not provide a clear answer to a

trivial case, in that the case does not fall squarely within the boundaries of one of the theory’s criterion, it

remains that the theory does not perceive the case to be ‘easy’ or trivial, but rather borderline and more

difficult. A theory which diverges from the positive law with respect to its perception of broadly consented-

to positions, i.e. ‘easy cases,’ especially within a field where such consensus is so rare, plainly does not

match the present body of law.

Thus, in seeking to find a criterion by which to test the major pre-contractual disclosure theories

with respect to the positive law, the following easy question, called the ‘base case,' has been chosen. The

question is as follows: Should a seller be required to voluntarily disclose information regarding a

competitor’s lower prices to a potential buyer?

It is assumed that there is broad juridical consensus regarding the answer to this question – a

resounding “no”, which should be consequently be reflected in a theory’s answer to the question, both in

nature and emphasis.8 In the later chapters, different theoretical approaches will be analyzed and applied to

the ‘base case,’ in an attempt to determine which theories successfully account for this widespread

consensus. However, before analyzing the theories themselves, it is important to understand the position and

nature of the ‘base case’ within the realm of pre-contractual disclosure – which will be the subject of the

following chapter.

Chapter II: 7 Methodological errors, such as the use of a small, unrepresentative sample size are considered a common cause of legal theories' inability to account for the positive law. Lee Epstein and Gary King, The Rules of Inference, 69 U. Chi. L. Rev. 1 (2002)8 The question was determined to be trivial following an informal survey made in the Hebrew University Law Faculty and by way of legal commonsense. Since the issue is assumed to be consented to, there is a lack of case law on the subject and thus difficult to prove using court decisions.

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The nature of the 'base case' as a pre-contractual disclosure issue

A. A Frequently Appearing Situation

The first distinguishing characteristic of the 'base case' is that it arises frequently within the body of

circumstances in which a disclosure decision must be made. Sales agreements are common, as are situations

in which a seller knows more than a potential buyer about a specific competitor's lower prices. Thus this

case may be considered part of the main body of situations where a disclosure impasse arises, and not a

fringe case.

B. Extrinsic Information

The second important quality of the 'base case' is that the data which it regards is extrinsic as

opposed to intrinsic to the contract9, in that competitor prices 'bear upon' the contract at the time of

negotiations but are not related to the character of the subject-matter (i.e. the product) of the agreement. The

'base case' is a type of market information, an important subgroup of extrinsic information, a type of

information identified as exempt from a disclosure requirement in the famous Laidlaw case.

In the landmark US pre-contractual disclosure case, Laidlaw v. Organ10, former US Supreme Court

President John Marshall first justified non-disclosure based on the status of the relevant information's

relationship to the contract, distinguishing between extrinsic and intrinsic data.11 When information is

related to factors external to the terms of the contract, e.g. the market price, Marshall determined that "the

means of intelligence are equally accessible to both parties,”12 hence justifying a non-disclosure policy.

Marshall's decision and the facts of the case were subsequently used as a basis for the leading

contemporary disclosure theories. His opinion and the facts of the case, however, have been considered

"cryptic"13, and justifying non-disclosure solely based on extrinsic circumstance has since been brought into

question.

A problem with distinguishing disclosure cases based on whether information is extrinsic or intrinsic

is that few disclosure cases involve extrinsic data14, and as such it is difficult to measure whether this

9 Joseph Story, 1 Commentaries on Equity Jurisprudence §210 (12th ed. 1877); 2 James Kent, Commentaries on American Law, 377 (1827). American legal historian Joseph Story defined the difference between intrinsic and extrinsic circumstance: "Intrinsic circumstances are properly those which belong to the nature, character, condition, title, safety, use, or enjoyment, ... of the subject-matter of the contract; such as natural or artificial defects in the subject-matter. Extrinsic circumstances are properly those which are accidentally connected with it, or rather bear upon it, at the time of the contract, and may enhance or diminish its value or price, or operate as a motive to make or decline the contract; such as facts respecting the occurrence of peace or war, the rise or fall of markets, the character of the neighborhood, the increase or diminution of duties, or the like circumstances."10 Laidlaw v. Organ, 15 U.S. 178 (1815)11 Joshua D. Kaye, Information, Disclosure, The Law of Contracts and the Mistaken Use of Laidlaw v. Organ, BePress, 2007. There is a considerable degree of misunderstanding surrounding Marshall's opinion, however the distinction based on the relation of the information to the contract (extrinsic/intrinsic) is the prevailing interpretation.12 Laidlaw. Marshall's language in the opinion is close to that of Prof. Kim Scheppele, in her theory of contractual non-disclosure, to be discussed in Chapter III.13 Krawiec and Zeiler, p.5; Kaye, p.7. Kaye notes that Marshall's distinction has "proved puzzling," since similar circumstances have led to divergent results. 14 Krawiec and Zeiler p.51. The source regards information about cases reaching the courts in the United States – presumably the situation is no different in Israel.

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distinction is truly significant. Kimberly Krawiec and Kathryn Zeiler proposes three theses as to why there

are so few 'extrinsic' disclosure cases, and argue that the most plausible explanation for this phenomenon is

that the uninformed party is generally unlikely to ever reveal the extrinsic information.15

C. Information Possessed by a Buyer in the Context of a Buyer-Seller Relationship

The third distinguishing characteristic of the data in the 'base case' is that it is part of the body of

knowledge possessed by the seller which is material to the buyer’s consent. Within the context of the buyer-

seller relationship, it is argued by a number of leading scholars16 that sellers should bear a relatively strict

burden of disclosure as compared with buyers, due to, as Kim Scheppele puts it, their "structurally superior

access to information"17. Professor Anthony Kronman18 contends that this disparity is reflected in the

positive law, as courts more frequently permit non-disclosure for buyers.19

Prof. Melvin Eisenberg concludes that beyond the fundamental asymmetry in access to information

between buyers and sellers, the buyer is more sensitive than the seller to changes in price resulting from

non-disclosure – a phenomenon known as loss-aversion.20

Eisenberg and Prof. Steven Shavell also assert that, in general, information possessed solely by the

seller and relevant to the buyer's consent is used primarily to drive up the price21 and is not acquired as a

result of costly research22. Consequently, Shavell contends that sellers will have sufficient incentive to

acquire information even with a disclosure requirement since they will be able to benefit from it without

risking a significant loss if the data is revealed.23

D. The ‘right’ answer to the ‘base case’ as a market necessity:

As previously mentioned, it is the assumption of this paper that the question posed in the 'base case'

is trivial. It seems intuitive that a seller need not voluntarily disclose the lower prices of his competitor, as

the risks associated with such data are allocated to the buyer.24 In searching for a remonstration for this

15 Ibid. p.5216Melvin A. Eisenberg, Disclosure in Contract Law, 91 Cal L. Rev. 1645 (2003); Kim Lane Scheppele, Legal Secrets: Equality and Efficiency in the Common Law (1998). Eisenberg and Scheppele both agree that a strict duty to disclose should be placed on the seller as opposed to the buyer.17 Scheppele, p.17018 His seminal economic approach to disclosure will be discussed in depth in Chapter IV.19 Anthony Kronman, Mistake, Disclosure of Information, and the Law of Contracts, 7. J. Legal Stud. 1 (1978).20 Eisenberg p.22; Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decision under Risk, Econometrica 47 (1979). Any price change resulting from seller non-disclosure will necessarily result in a loss for the buyer, since the seller will only withhold information that will drive up the price. The significant psychological tendency to prefer avoiding losses than achieving gains is known as loss-aversion – coined by Prof. Daniel Kahneman and Prof. Amos Tversky as part of their Prospect Theory. Since the seller risks foregone gains while the buyer risks the same amount in losses if non-disclosure is allowed, such a policy creates a buyer-seller power asymmetry. 21 Eisenberg, p.3622 Eisenberg, p.25. This is similar to Kronman's criteria for disclosure, which will be discussed in Chapter IV.23 Steven Shavell, Acquisition and Disclosure of Information Prior to Sale, 25 Rand. J. Econ. 20 (1994)24 How a seller should respond if asked about the prices of his competitor does not benefit from the same consensus, while the issue of disclosure duties when responding to questions is a broad and controversial topic in its own right. Theorists such as Randy Barnett and Saul Levmore even argue that in certain situations it may even be desirable to fabricate an answer if the question asked is inappropriate.

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assumed fait accompli, it may seem prima facie that market necessity is the underlying reason for this

consensus, however in final analysis this justification is unconvincing.

If sellers were required to voluntarily disclose the lower prices of their competitors, one may initially

view the result as a likely disaster for the respective market, using reasoning similar to that of Akerlof in his

'Market for Lemons' model.25 The model concludes that a lack of consumer knowledge of the latent defects

of products within a market will lead to the eventual deterioration of product standards within that market.26

As such, a disclosure requirement for latent defects may effectively maintain market standards.27

Similarly, one may conclude that if sellers were to be required to voluntarily divulge the lower prices of

their competitors, they would be unable to effectively profit from a higher price – thus forcing the sellers to

assume the only profitable price to be the lowest one in the market. As a result, prices would all be driven

down to a low uniform rate, unless they were coordinated between sellers in a manner incompatible with

anti-trust law. Such a situation would discourage competition and eventually form large barriers to entry

into the market – since only large sellers/producers would be able to profit from the low prices in the

market. A lack of market competition would lead to a lack of innovation, resulting in market stagnation.

Much as the above picture seems dim, an alternate prediction of such a disclosure requirement

forecasts a much brighter future. Rather than forcing prices down and smaller sellers out of a market, a

disclosure requirement would simply force producers/sellers to differentiate their products in order to

maintain their prices. Sellers, rather than relying on consumer ignorance, would have to provide

distinguishing features or services in order to maintain their prices. Such a policy could, in this case,

predictably increase the quality and differentiation of services and products in such a market.

Due to the lack of one unifying market scenario necessitating a non-disclosure requirement

regarding the 'base case,' it follows that there must be other reasons for the consensus regarding the

allocation of responsibility to the consumer to reveal a competitor's prices.

Chapter III:

The 'fairness' approaches

25 George A. Akerlof, The Market for 'Lemons': Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics 84 (3) (1970) 488–500.  The model is as follows: When there is no reliable knowledge about the quality of a product– consumers are forced to assume that the product's quality is as low as possible. Thus they are unwilling to pay a higher price for a higher quality product, and consequently all producers gradually reduce the quality of their product until consumers know the value of the product.26 The more general phenomenon in which information asymmetry leads to market deterioration is known as 'adverse selection'.27 Richard Craswell, Taking Information Seriously: Misrepresentation and Non-disclosure in Contract Law and Elsewhere, 92 Va. L. Rev. (2006). Craswell argues that the end-goal of improving the quality of products is central to many fields of regulation, but is generally (and mistakenly) absent from the pre-contractual disclosure debate.

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The term 'fairness' must be separated from 'perception of fairness,' the latter of which is the subject

of the section. To declare a group of outcomes to be 'fair' is to assert the predominance of certain values 28,

and is a fitting topic for a normative debate. 'Perception of fairness,' on the other hand, leaves the normative

underpinnings of a 'fairness' criterion unquestioned while analyzing the role of such a standard in judicial

decision-making – thus determining whether it is truly perceived to be fair and the extent of its importance

in establishing the positive law.29

Fairness regarding the pre-contractual duty to disclose may be viewed ex ante or ex post with respect

to the negotiations process, or simply in relation to existent social norms.30 That is, respectively, a 'fairness'

condition may require that bargaining occur from a position of equality, that the negotiated result be

considered 'fair,' or that the bargaining process be conducted according to existent social standards, i.e.

good-faith.

Fairness in contractual relations is guarded by doctrines such as the principle of good faith or

unconscionability, which at times stand at odds with the economic approach to pre-contractual disclosure.

For Good-faith theorists such as Eric Holmes and Friedrich Kessler, equality of access, the main subject of

this section, may be one of the indicators determining whether the obligation of good faith requires pre-

contractual disclosure.31 The most fully-developed fairness theory with regards to pre-contractual disclosure

belongs to Professor Kim Lane Scheppelle32, however contends that equality of access is the sole

determinant the pre-contractual duty to disclose.

A. Equal Access

Scheppele is the major proponent of determining the pre-contractual disclosure requirement on these

grounds, claiming that equality of access is the most effective basis for determining disclosure both

positively and normatively. 33 Much like Kronman, she argues that her theory ultimately explains Marshall's

decision in Laidlaw.34 Similar to Marshall, she does not require disclosure of extrinsic information,35 but argues that Marshall’s extrinsic/intrinsic distinction is outdated and does not reflect the current positive law.36

Scheppele’s justification for solely basing the disclosure requirement on equality of access is via the

contractarian view that laws are legitimate solely if they may be presumed to be consensual.37 This approach

holds that it may be recognized that laws bear such consent if they contain "those values and arguments that

28 Duggan, Bryan, Hanks, p.12329 Ibid., p. 12230 Ibid., p.123. 31 Ibid., p.13732 Ibid., p.12333 Ibid., p.14134Kaye, p.18; Scheppele, p. 107; Strong v. Rapide, 213 U.S. 419 (1909). Scheppele cites a 'similar' case where disclosure was required, Strong v. Rapide, as evidence of this notion. 35 Scheppele, p.13336 Ibid., p.128-29.37 Ibid., p. 60

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the losing side in a legal case would recognize as appropriate, even when the person finds oneself losing as a

result of their application".38

Scheppele arrives at the above conclusion by way of philosopher John Rawl's method of determining

whether a law is consensual. He concludes that the only true consent to a legal rule may be acquired before

people have knowledge of any aspect of their status in society,39 since only under those conditions, when

one is ignorant of his position in society, a rational actor will act to “promote self-interest in a broader [more

social] perspective.”40 Under such artificial circumstance, which Rawls terms a "veil of ignorance," he

argues that the decisions made by an actor will be made in order to optimally preserve his access to

opportunities in society.

Scheppele adopts Rawl's theory with one caveat: She argues that rational actors in society must be

given certain crucial facts about the society and legal system framing the legal rule upon which they are

deciding, so that the 'veil' is one of tempered and not utter ignorance.41

Within the regular body of disclosure cases in which disclosure is an issue, Scheppele concludes that

both parties should have some ‘non-trivial chance to win,’42 where victory is defined as the gain from the

information in question. Consequently, she decides that disclosure should be required in cases in which one

party does not have a significant chance at "winning," and labels the undisclosed information a “deep

secret”43. Cases where one party is not immediately privy to certain pieces of information but has some

chance at revealing the information are cases where the undisclosed constitutes a “shallow secret”44.

Scheppele's principle is that deep secrets must be disclosed while shallow secrets need not, unless

the ignorant party falls into either of the two following categories: the uninformed party bears a structural

asymmetry in the access to knowledge between parties,45 such as that between a buyer and seller regarding

the quality of a product; or the ignorant party is fundamentally limited in his ability to make decisions, due

to either an intellectual, social or economic shortcoming.46

Scheppele concludes that disclosure is not required if both parties have equal access to the

information in question, defining 'equal access' as the possession of “(1) equal probabilities of finding the

information if they put in the same level of effort and (2) are capable of making this equivalent effort.”47

B. Scheppele and the ‘Base Case’ as a Shallow Secret

As noted at the end of the previous chapter, market considerations fail to reflect the nature and

emphasis of the answer to the 'base case.' Equality of access conversely provides a more natural and

38 Ibid., p.6139Ibid., p.6640Ibid., p.7141 This difference may be explained by a difference in scope: While Rawls seeks consent to the basic legal structure of society, Scheppele seeks consent to legal rules already existing within a pre-built society with an existent legal framework.42Ibid., p.7543Ibid., p.7544Ibid., p.7545Ibid., p.12046Ibid., p.12047Ibid., p.120

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convincing answer. Despite the asymmetry in access to information characterizing the buyer-seller

relationship, information about a competitor’s prices is highly accessible to even the most ignorant potential

buyer, unlike other sorts of market information48, the existence of which a buyer may not even be aware. As

such, since practically all buyers will be aware that there may be a competitor with lower prices, the

information in the ‘base case’ epitomizes a “shallow secret”. Therefore, not only does it seem that

Scheppele’s theory provides the right answer to the base case, but her theory provides the requisite emphasis

in answering the question.

C. Criticism of Scheppele’s ‘Equal Access’ Theory

Scheppele’s theory is criticized on both normative and positive grounds. Normatively, her theory is criticized for being too open-ended, vague49, and subjective – as providing "no meaningful guidance for courts"50 to determine whether a situation requires disclosure. Easterbrook argues that the term 'equal access' is void of significance, since no two

people ever have equal access - and as such the law must endure a degree of inequality in order to be

practical.51 Michael Trebilcock further criticizes Scheppele for not sufficiently emphasizing the importance

of information production, while focusing too much on information-sharing.52

Trebilcock also argues that her theory fails to differentiate between situations where one party

suffers an incredible loss and those in which the loss to either party is marginal, since her theory is based on

the nature of the parties and not the terms of the proposed agreement. He also adds that her key terms

possess an inherent ambiguity which doesn’t afford one to truly distinguish between equal and unequal

access to information, thus concluding that nearly any court ruling may be viewed as corresponding to her

theory.53

C. The “It’s Just Not Right” Intuitive Approach

An interesting justification for the 'base case' is an intuitive quasi-approach, coined the "it's just not

right proposition" by Prof. Henry Manne in his discussion of insider trading in the securities market.54 The

approach utilizes public perception of fairness as an indicator of desirable legal policy. While Manne argued

48 Compare, for example, the information in Laidlaw to the 'base case'. In Laidlaw, although the market information was accessible to both parties, knowledge of the existence of information regarding a competitor’s prices seems far more present in any potential buyer’s psyche. 49 Duggan, Bryan and Hanks, p.20150 Krawiec and Zeiler p.2251 Duggan, Bryan and Hanks, p. 202; Frank. H. Easterbrook, Insider Trading, Secret Agents, Evidentiary Privileges and the Production of Information, Supreme Court Review 11 (1981), p.330.52 It is unclear, however, whether Scheppele's equal access approach gives priority to “information-sharing” over “information-production”. If she gives priority to data production, then her theory shares a substantial likeness to the law and economics approaches. Conversely, if she favors information-sharing, then there may be a problem with her fundamental claim of legitimacy using Rawl's "veil of ignorance". 53 Michael Trebilcock, The Limits of the Freedom of Contract, (Cambridge: Harvard University Press, 1993), p.111. 54 Henry Manne, In Defense of Insider Trading, Harvard Business Review 44 (1966), p. 113

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against the use of such propositions, deeming them academically unproductive55, other scholars agree that a

gut-level sense of unfairness "cannot be ignored".56 In the same vein, a preliminary justification for the

consensus view regarding the 'base case' is that it 'just doesn't seem right' to people. The widespread accord

with respect to this question may be a sign of our basic intuitive sense that injustice would be inflicted upon

the seller were he to bear the burden of disclosure.

Later academics found efficiency-based explanations for the intuitive sense of unfairness in allowing

insider trading. Their explanation, "only one step removed from foot-stamping [Manne's other name for the

'just not right propositions']", is that investors would be reluctant to invest in a market thought of as unfair.57

In order to determine a more broad policy of pre-contractual disclosure, one must determine which

situations people perceive as fundamentally fair. Hoffman and Spitzer, in a 1985 study, found that people

only view unequal chance distributions, competitive circumstances in which one party has an advantage

over the other, as fair if the winner has earned entitlement to his preferred status.58 This may support the

economic approaches to the disclosure dilemma, which grant disclosure exemptions to those parties which

earn entitlement. A study conducted one year later argued that a business deal would be perceived as more

unfair when losses were increased as opposed to when gains were reduced. This phenomenon, as mentioned

in Chapter II, is called "loss aversion".59

Chapter IV:

Economic Theories

A. Introduction

55 Gary Lawson, The Ethics of Insider Trading, Harvard Journal of Law and Public Policy 11 (1988), p.77656 Ibid, p.775 57 Duggan, Bryan and Hanks, p.12358 E. Hoffman and M. L. Spitzer, The Coase Theorem: Some Experimental Tests, Journal of Law and Economics 25 (1982), p.73 59 Kahneman and Tversky, p.263-291.

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In his book, Economic Analysis of Law, Professor and Judge Richard Posner explains that the

aspiration of the law and economics approach to law is to interpret legal phenomena via principles of

efficiency.60 Although Posner makes clear that these principles have been subject to a number of criticisms61,

he notes that the school of law and economics, of which he is a founder, has survived longer than other

approaches, and predicts further increases in its significance. He highlights the following ideal functions of

contract law so as to ensure efficiency: First, the role of the law is to protect a weaker party from

opportunistic behavior and both parties from avoidable mistakes; Second, the law should allocate risk to the

better equipped risk bearer and determine efficient terms; and lastly the law should reduce the costs of

resolving disputes. Within the context of the disclosure dilemma, each of these functions, apart from the

last, plays a central and sometimes conflicting role62 in determining the preferred and most efficient rule.

More specifically, the economic approach to pre-contractual negotiations incorporates market

efficiency into the spectrum of concerns determining disclosure policy. Despite the pervasiveness of both

the economic approach to law in general and specifically with regards to pre-contractual disclosure, the

approach generally suffers from a large disparity between recommendations of the law and economics

literature and court decisions.63 The application of these theories to the ‘base case’ will highlight this gap.

B. Kronman’s ‘Procedural Approach’ Focusing On Allocative Efficiency

The landmark economic approach developed by Professor Anthony Kronman bases a disclosure

requirement on the general64 procedure by which information is acquired. He founds this approach on the

premise that disclosure may provide disincentive to discover essential information, and in situations where

such discoveries occur it would be inefficient should the researcher be required to disclose his revelations.

Kronman distinguishes between two types of research: That which results in information which is

deliberately acquired and thus protected from disclosure, and that which is adventitiously acquired and must

be disclosed. According to Kronman, those who acquire information fue to these incentives will effectively

relay the data to the market by offering a price reflective of this knowledge, thus contributing to the

accuracy of market prices. Thus market actors will be better-equipped to decide which resources are worthy

of investment.65 The sort of efficiency reached in such a state is allocative, in that it optimizes the

60 Richard A. Posner, Economic Analysis of Law (New York: Aspen, Sixth Edition, 2003), p.2761 Ibid., p. 26,27. The Law and Economics approach is mainly criticized for having a conservative political bias and for neglecting justice and fairness concerns, contentions which Posner refutes. Ronald Dworkin argues, for example, that economic efficiency is itself neither an inherently attractive social goal nor a component of an inherently attractive social goal. Jules Coleman argues that the efficiency of legal rules is not correlated with otherwise attractive social goals, such as consent by those affected by the rules or the advancement of utility for those affected by the rules. Critical Legal Studies scholar Mark Kelman, a radical critic of economic analysis, argues that efficiency criteria are so indeterminate that decision makers cannot apply them consistently or meaningfully. 62 These principles tend to conflict with each other within the realm of pre-contractual disclosure. For example, within Kronman's theory the interest of preventing avoidable mistakes conflicts with the determination of efficient terms and proper assignment of risk.63 Ofer Grosskopf and Barak Medina, A Revised Economic Theory of Disclosure Duties and Break-Up Fees in Contract Law, (SSRN, 2006), p.22. Krawiec and Zeiler, p.19 – This policy may be seen regarding the issue of reimbursement for reliance costs when negotiations fail – courts don't usually require such reimbursement, despite the 'vigorous' support of law and economics scholars.64 Kronman focuses on classes of cases, rather than specific cases – in determining if the requisite amount of effort exists.65 Eisenberg, p.31

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distribution of resources within the market – deciding the most efficient way to divide the “market pie.” 66 In

this sense Kronman’s vision of efficiency is fundamentally different from the other major class of economic

approaches to disclosure, which emphasize making the “market pie” larger. 67

Kronman’s major breakthrough is his differentiation between casually and deliberately acquired

information, but recognizing that it is impossible for courts to use this criterion in each case he instead

proposes to “apply a blanket rule (of disclosure) across each class of cases involving the same sort of

information.”68

It is unclear what 'blanket rule' would apply to the 'base case'. On the one hand, information

regarding a competitor's prices may be viewed as part of a class of information69 deliberately acquired by the

seller in order to better understand his market, or conversely seen as adventitious information acquired by

mere virtue of the seller's presence in the market. This lack of clarity is incongruent with the emphatic and

clear answer resounding from the 'base case'.

The normative justification of Kronman’s theory is that it aspires to efficiently allocate resources

towards the production of goods with the highest utilities. However, not all markets involve production, and

as such Kronman implicitly limits non-disclosure of deliberately acquired information to markets generally70

involving production and not only exchange, as opposed to those in which the ‘pool of exchanged goods

remains constant.’71

As mentioned in Chapter II, Kronman asserts that courts more frequently permit non-disclosure for

buyers rather than sellers. This assertion matches his analysis if one assumes that data acquired by buyers is

by and large a result of deliberate investment, as opposed to that obtained by sellers – who attain such data

more casually, as a result of their possession of the asset being sold.72 This proposition leads to the

conclusion that the information in the ‘base case,’ data obtained by the seller – should be disclosed

according to Kronman’s criteria since it is part of the class of information generally acquired casually.

B. Criticism of Kronman’s approach:

In kinship with Scheppele’s theory, Kronman's approach has been widely. First, it is criticized on a

positive basis for not successfully embodying the majority and essence of disclosure cases.73 Disputes

arriving in court where the deliberate investment of one of the parties is an issue are "relatively rare," 74

66 Kronman, p.26. He emphasizes “the importance of information in allocating social resources to their highest valued uses.”67 Eisenberg, p.22 68 Kronman, p.3769 Such as relevant market information, perhaps.70 Kronman’s generalizations about the nature of a market are related to his “blanket rule” method of analyzing disclosure cases.71 Kronman, p.7 – supra note 34; Eisenberg, p.31. Eisenberg adds that this distinction may have been considered “trivial” by Kronman because he thought that most markets involved production. Kronman argues that the information in Laidlaw contributed to the “the allocation of social resources” in deciding which good to produce and for that reason the deliberate acquisition of such information justified non-disclosure. If the information in question in Laidlaw was one of “pure exchange,” one in which neither party to the contract was a producer of the good transferred, he essentially implies that the outcome of Laidlaw would have been different.72 Federal Deposit Insurance Corp. v. W. R. Grace & Co,, 877 F. 2d 614 (7th Cir. 1989) cert. denied U.S. 1056 (1990).73 Krawiec and Zeiler, p.5374 Virg. Law article: *569

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whereas most cases involve information revealed during the “ordinary course of business”75. Normatively,

Kronman’s theory is also admonished for its assumption that all deliberately acquired information

encourages allocative efficiency.76 In addition, Scheppele chides the scope of Kronman’s thesis for not

necessarily requiring disclosure in fiduciary relationships. 77

Likewise, the deliberate/casual distinction is carped for not being a significant factor in juridical

decisions regarding fraudulent silence.78 Kronman's distinction is considered a less prominent factor than,

for example the equal access distinction or nature of the relationship between the contracting parties.79

More generally, Kronman's assumption that the discovery of useful information is necessary may be

mistaken, despite the utility derived.80 Thus, even if the addition of useful information will benefit a market,

it does not follow that the imposition of a rule encouraging such behavior is legally efficient.81 In fact, if the

cost of acquiring such information is greater than the utility it provides, then such a rule would be decidedly

inefficient.82

Israeli scholars Medina and Groskopf reject the use of Kronman’s assumption that using non-

disclosure as an incentive to conduct research in all cases is necessary, effective83 or both. They argue

That non-disclosure is unnecessary in the many cases where the knowledgeable party deliberately acquires

information in order to improve his position against third parties, in addition to his bargaining partner, and

disclosure would not prevent him from preserving an advantage against these third parties. 84 Thus no legal

incentive to acquire information in these situations may be necessary. In other words, the disclosed

information still ensures the buyer a margin of “standard profit”85 due to the advantage attained over

competitors, although profits taken from one’s bargaining partner may be foregone.86

Consequently, in order to understand if there is such competition between third parties they

recommend that each market be evaluated in order to determine the validity of using non-disclosure as an

incentive-protecting mechanism.87

They also propose that deliberately acquired information may be subdivided into ‘conventional’ and

‘exceptional’ methods of acquisition, the latter of which is the result of an expensive, non-standard research

process. Accordingly, only ‘exceptional’ information is exempted from disclosure. 88

C. Barnett's allocative approach:

75 Virg. Law art icle: *56976 Eisenberg, p.2977 Scheppele’s book, p.161-278 Grosskopf and Medina, pp.15-16; Krawiec and Zeiler, p.5479 Krawiec and Zeiler, p.64. For example, if the parties have a fiduciary-beneficiary relationship. 80 Veller, p.7481 R.L. Birmingham, The Duty to Disclose and the Prisoner's Dilemma: Laidlaw v. Organ, Will. & Mary L. Rev. 29, p. 258,25982 Veller, p.7583 The effectiveness of a disclosure requirement will be discussed in the sub-section of this chapter dealing with break up fees.84 Grosskopf and Medina, p.2485 Ibid., p.2486 Ibid., p.2487 Ibid., p.2788 Grosskopf and Medina, p.26

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A proponent of using disclosure to achieve allocative efficiency, Randy Barnett agrees with

Kronman’s objective but not with his distinction. Limiting his discussion to transactions involving scarce

resources, he asserts that any information contributing to such ends be exempt from disclosure regardless of

the ‘process’ by which it was acquired.89

According to Barnett's approach, the information in the 'base case' need not be disclosed if it

contributes to allocative efficiency within the market.90 Assuming that a seller would capitalize on his

revelation of a change in competitor prices, such information would likely affect the transaction price,

moving the overall market price in an ‘information-revealing’ direction, however marginally.91 On the other

hand, since the information in the ‘base case’ is probably already present within the market, the data may

not be of importance to Barnett since any shifts in resource allocation would have already occurred.

If one does assume an allocative value to the data in the ‘base case,’ the information, much like that

in Laidlaw, represents the essence of Barnett’s theory, for it is the same sort of ‘hard case’ where the

allocative benefits of the transaction are marginal. 92 He asserts that even if the information in question

would be revealed momentarily, it contributes to forging a more accurate market price more quickly if used.

He emphasizes that the significance (or insignificance) of the contribution is irrelevant, explaining that the

aggregate of all of these transactions which determine the market price – and not each one by itself – and

that each one of many transactions is important.

However in cases similar to the ‘base case’ and Laidlaw, in which the social benefit of non-

disclosure is marginal, such revelations may end up being more costly overall to society - if the cost of

acquiring such information surpasses the allocative utility derived.93 When regarding these types of

information, which distinguish Barnett’s theory from Kronman’s and those centered on productive

efficiency, this overall social loss becomes more likely – and Barnett’s argument is weakened. 94

Barnett also reasons that most of the disclosure cases which distinguish his theory from the others do

not involve information which will momentarily be revealed to the market, as in Laidlaw and the ‘base

case,’ and as such the benefits reaped by non-disclosure are usually more significant. The frequently

appearing ‘base case,’ however, sheds doubt on this conclusion.

D. The “consequential” approach: focusing on productive efficiency

The other major economic approach may be described as ‘consequential,’ as it grants a disclosure

exemption if the information produces social benefit, increasing the wealth per capita of each market actor.

While Kronman's and Barnett's approaches focus on allocative efficiency95 as their aspiration, this aim is

aptly named productive efficiency96.

89 Randy E. Barnett, Rational Bargaining Theory and Contract: Default Rules, Hypothetical Consent, The Duty to Disclose and Fraud, Harv. J. of L. & Pub. Pol'y 15 (1992), p.798.90 Ibid., p.78691 Ibid., p.78792 Barnett argues that non-disclosure of the information in Laidlaw contributed to allocative efficiency in spite of the fact that the information was about to be revealed to the market regardless of the transaction.93 Eisenberg, p. 36. 94 Ibid., p.3795 Allocating resources to their optimal possessor.

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Questioning when an investment in information was socially efficient, Jack Hirshleifer first

distinguished between discovered information which "makes the pie larger"97 and foreknowledge,

information creating wealth only for the information bearer at the expense of the other negotiating party,

forging a basis for this set of theories.98 He argued that the acquisition costs of foreknowledge exceeded

their social value and should not be legally encouraged.

Robert Cooter and Thomas Ulen formally applied Hirshleifer's theories to the field of pre-contractual

disclosure, drawing a similar distinction between productive and redistributive information. While

productive data is used to produce more wealth, redistributive data serves solely as a bargaining advantage

for its bearer.99 Since the acquisition costs of redistributive information exceed their social benefit, the

information is unworthy of a disclosure exemption.100 Other law and economics theorists use similar

distinctions. Prof. Steven Shavell draws a distinction between foreknowledge and socially valuable

information101, as does Professor Ronald Coleman, distinguishing between what he terms “technological”

and redistributive information.102

Overall, this body of theories has been considered problematic in application since most information

contains both productive and redistributive qualities, and may not be clearly categorized as one or the

other.103 The information in the ‘base case’ is clearly redistributive since it regards information already

present within the market, and thus cannot ‘make the pie larger.’ Thus none of the 'consequential'

approaches would consider it worthy of a disclosure exemption, amounting to a contradiction between it and

the consensus view.

E. Posner's view on disclosure – A Reductive Approach

Richard Posner contributes a simpler approach, contending that one should usually disclose

information acquired at a lower cost than would one’s bargaining partner.104 He argues that “the case for

requiring disclosure is strongest when a product characteristic is not ascertainable by the consumer at low

cost.” The purpose of this distinction is to ‘allocate risk to the superior risk bearer,’ the party which is best

equipped to perform the required research.

This criterion too suffers from problems in positive implementation, since – as will be shown when

applied to the 'base case' – it is unclear in many situations which party can acquire the information at a

lower cost. Posner's method is also criticized, much like Kronman's distinction, as being over-inclusive and

96 Eisenberg, p.35. Such information can be used to produce more wealth for society, as opposed to redistributive information, which only benefits its possessor during negotiations. 97 John Hirshleifer, The Private and Social Value of Information and the Reward to Inventive Activity, Am. Econ. Rev. 61 (1977) p.651.98 Ibid; Eisenberg, p.35. Hirshleifer's theory influenced Kronman's, and preceded it by four years.99 Robert Cooter and Thomas Ulen, The Economics of Contract Law (1986)100 Ibid., p.35101 Shavell, p.26102 Barnett, p.800103 Veller, p.76104 Posner, p.113. He argues that “Liability for nondisclosure should depend on which of the parties to the transaction, seller or consumer, can produce, convey, or obtain the pertinent information at lower cost.”

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not accounting for other contributing factors, such as the nature of the relationship between the two

parties.105

With regards to the 'base case,' Posner's theory remains unclear. Although the seller may likely

possess superior access to the information, his advantage is nominal. To complicate things, the 'superior risk

bearer' may in fact be the buyer and not the seller, who already bears a responsibility to himself to seek out

the best price.

F. Eisenberg: An Integrative Approach

Seeking to weather the implementation problems of the economic theories previously cited, UCLA

Professor Melvin Eisenberg compiled a large number of principles outlining the duty to disclose, creating a

comprehensive law and economics-based approach. His normative framework contains a system of

overarching disclosure rules, much like the previous theories – but unlike the other methods, he includes a

number of exceptions to each of the rules. His fundamental principle, which he calls ‘The Disclosure

Principle,’ requires disclosure of “material facts except in those classes of cases in which a requirement of

disclosure would entail significant efficiency costs.”106 He incorporates both the ‘procedural’ and

‘consequential’ approaches to disclosure in determining this efficiency criterion, requiring disclosure in

cases where data was either acquired adventitiously or when it considered foreknowledge.

Eisenberg also provides special exceptions requiring disclosure when information was acquired

improperly or if the parties were in a fiduciary or other trust-based relationship, an element only present in

Scheppele's theory.

He adds a final set of three circumstances (of which only two are relevant) justifying a disclosure

exemption, unless those situations involve fiduciary relationships or an improper method of information

acquisition. It is within these three exceptions that his answer to the ‘base case’ may be interpreted. The first

circumstance is one in which the information-bearing party has information regarding a risk allocated to that

uninformed party – similar to Posner's criterion.107 In other words, regardless of the social value or effort

involved in discovering a piece of data, if there was explicit or implied consent that the burden of the risks

regarding that data would be placed on the uninformed party, disclosure is not required. Eisenberg doesn’t

highlight the reasons for the allocation of such risk to the uninformed party, beyond being common trade

practice or an existent or implied contractual provision.108

It is within the context of this condition that the correct answer to the ‘base case’ is found, since non-

disclosure of competitor prices is clearly common trade practice, as seen by the broad consensus regarding

this practice. However, Eisenberg's theory does not shed light on the reasons for this broad consensus,

105 De Mott, p.74: Posner was the presiding judge in the W.R. Grace case (previously cited), in which the court obligated a buyer to disclose to a seller a change in the financial situation of his guarantor. In a later case, however, a seller was not obligated to inform a buyer's guarantor of a change in the financial state of the buyer. Posner's theory is criticized by De Mott for not being able to positively differentiate between these two cases, and reaches the conclusion that his distinction is over-inclusive.

106 Eisenberg, p.9107 Ibid., p.42108 Ibid., p.46

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instead utilizing it as evidence of a specific risk allocation, an efficiency consideration. Thus, although

Eisenberg clearly answers the 'base case' in a desirable manner, it is not via his 'Disclosure Principle' or

another efficiency consideration, perhaps implying that efficiency is an improper norm for the 'base case.'

Eisenberg's second supplementary condition justifying non-disclosure regards states where the unknowing

party was "on notice that his mistaken assumption was unfounded" or could have revealed the information

had he conducted a reasonable search.109 This exception also provides the correct answer to the 'base case', if

one considers the broad consensus as evidence of an appended contract placing the buyer on ‘notice’ to

conduct a ‘reasonable search’. The first exception, however, more properly describes the ‘base case’, since

it directly answers the question using widely accepted social norms rather than using them as a source of

authority to implement court-driven legal principles (the objective 'reasonable search' standard).110

He advocates a more stringent disclosure requirement for sellers due to the following attributes

within the buyer-seller relationship: An advantage in access to information relating to their product, which is

by and large adventitiously acquired; a risk of foregone gains as opposed to losses when disclosure is

required111; and a pre-existing 'adequate'112 incentive, regardless of disclosure policy, to research their

product and market – due perhaps, as Medina and Groskopf mention, to their competition via third parties.113

Market information, however, is considered by Eisenberg to be to be distinct from other information

revealed within the buyer-seller context, and thus possibly exempt from seller disclosure. This is because he

characterizes such data as equally accessible to both buyer and seller, using Scheppele's criterion, and for

the most part deliberately obtained by the seller, using Kronman's distinction.114

Eisenberg, nevertheless, refrains from clearly advocating non-disclosure of such data, citing six

justifications for such a policy. First, he notes that market information has the potential to cause greater

harm to the buyer115 and is commonly foreknowledge116. Third, he maintains that the seller possesses an

inherent incentive to obtain market information regarding his/her product and that a disclosure requirement

would have little effect on “law and practice,” since it would not provide a significant disincentive to

perform such research.117 Finally, he adds that such data is psychologically more important to buyers than

sellers – since non-disclosure regards losses for the buyer and foregone gains for the seller.118

Thus, despite his two implied correct answers to the 'base case' described above, Eisenberg

ultimately illuminates a fundamental reason why the information in the 'base case' should be disclosed. If

the data has the potential to cause greater harm (both actual and psychological, as mentioned above) to the

buyer despite the symmetry of access between the two parties, then allocation of harm should be weighed 109 Ibid., p.46110 Ibid, p.28. The third condition Eisenberg adds provides a disclosure exemption in situations where buyers systematically take advantage of seller mistakes and miscalculations made by sellers, highlighting the asymmetrical protection he gives to buyers.111 As mentioned previously, due to the loss aversion effect, foregone gains are psychologically preferable to losses.112 Ibid., p.28113 Ibid., p.28114 Ibid., p.29115 Ibid., p.29. He says that “even market information held by a seller is information that will result in a loss to the unknowing buyer, rather than a forgone gain.”116 Ibid., p.29. Hirshleifer, Shavell, Cooter and Ulen all advocate disclosure of foreknowledge in their theories.117 Ibid., p.29118 Ibid., p.29. His conclusion is derived from the loss-aversion effect, part of Kannehman’s and Tversky’s Prospect Theory.

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alongside equal access. This leads to a seller disclosure requirement in cases where this is a significant

disparity in harm, in spite of equal access. Although prima facie this may seem a significant amendment to

Scheppele's theory, considering the allocation of harm may in fact be similar to the exceptions Scheppele

provides for deep secrets. On the other hand, unlike Scheppele's exceptions, the magnitude of potential harm

is directly related to the monetary scope of the contract – since a small harm asymmetry can translate in to a

significant difference if the transaction regards a large sum of money. This is precisely Trebilcock's

criticism of Scheppele's theory, in that it does not differentiate between incredible and minute losses.

Eisenberg also concludes that a disclosure requirement for market information would have little effect on

‘practice,’ implying that efficiency considerations may not be the driving force behind disclosure policy

regarding the 'base case.'

Unequally drawing on elements from the ‘procedural’ and ‘consequential’ approaches, Eisenberg

ultimately prefers the latter and its vision of productive efficiency. He criticizes Kronman’s and Barnett's

approaches, arguing that allocative efficiency will not be achieved in cases similar to Laidlaw since the

market advantage afforded by use of such foreknowledge, a head start in re-allocating resources, is usually

less than the time required to re-allocate the resources themselves.119 Accordingly, he determines that it is

unlikely that an allocational decision will be made during the span of time afforded by such information. 120

He concludes that productive efficiency is a better-suited goal of disclosure policy, since its basis in the

'substantive character' of the information (socially productive or not) is a better indicator of the positive

effects the data would have on the market. He prefers of Hirshleifer and Shavell’s distinction between

foreknowledge and socially valuable information over Cooter and Ulen’s productive/redistributive

distinction, pointing out that most cases are covered by both tests but the courts will find it easier to identify

foreknowledge as opposed to redistributive information.121

G. Non-Disclosure vs. Break-Up Fees

Broadening the spectrum of analysis, use of a disclosure exemption may be viewed as an attempt to

prevent one type of contractual hold up, a situation in which a negotiating party is forced to accede to

disadvantageous demands by the other side due to a circumstance of substantial need.122 This situation may

be one where a party making a substantial investment towards the enactment of a contract is left vulnerable

as a result, and is thus forced to agree to detrimental terms in order to prevent the breakdown of negotiations

and the total loss of the amount invested. Regarding the disclosure debate, a party in possession of

information worthy of protection is similarly in danger of suffering a substantial loss at the hands of the

non-bearing party if his information remains unprotected. Although a disclosure exemption is one legal

technique that may prevent the information-bearing party from being "held up," it may be lacking in

comparison to other preventative measures.119 Ibid., p.32120 Ibid, p.33121 Ibid., p.33122 Steven Shavell, Contracts, Holdup, and Legal Intervention. Harvard Law and Economics Discussion Paper No. 508. (2005), p.1.

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Scholars Barak Medina and Ofer Grosskopf argue that in situations similar to those that Kronman

envisioned, where one party has deliberately invested in acquiring information, abstention from disclosure

may not successfully give the investing party enough of an upper hand in negotiations to protect his

investment, since by mere virtue of the asking price, the information may be revealed.123 They add that

alongside the inefficacy of a disclosure exemption in these situations, using pre-contractual reliance as a

shield against hold up will be unsuccessful since the other party did not induce the investment costs.124

Consequently, due to the need for a more effective alternative to a disclosure exemption and the inability to

use the reliance doctrine, they propose the use of break-up fees in these situations, sums paid to a party for

their pre-contractual expenses if negotiations fail.125

There is little danger of contractual hold up in the 'base case,' since the information involved is not

likely to be acquired at a significant cost. However, the principle of hold up itself provides insight into the

broad consensus regarding this case: If the seller is forced to divulge competitor prices, this provides the

buyer with a degree of leverage which may be used against the seller. This may be the root of the broad

perception of unfairness leading to a disclosure exemption in the 'base case.'

H: A Flipside to Kronman – Preventing Over-Investment:

Medina and Groskopf also argue that non-disclosure of certain facts may lead to an over-investment

in information by the uninformed party. For example, when information about the likelihood of performance

is withheld by a party, such as in Hoffman v. Red Owl126, the uninformed party may invest far more than

befits the expectation of performance. Medina and Groskopf stop short of mandating a disclosure

requirement in such situations, claiming that it would be too difficult to enforce, and instead propose

shifting the reliance costs to the information-bearing party.

Due to the relatively symmetrical access of information between buyer and seller regarding market

information, excessive investment is not a relevant danger to the ‘base case,’ since any information withheld

from the buyer may be reasonably acquired.

Chapter V:

Concluding Remarks

Pre-contractual disclosure law suffers from a tension regarding the legal properties of the

information revealed. Data relevant to the negotiations process may be considered either the quasi-property

of its possessor, or material vital to the opposing party in deciding whether to consent to the exchange of his

rights as part of his agreement with the former. Instances in which disclosure policy is determinate may be

seen as a clear decision to define one of these properties as supreme over the other. For example, when

123 Grosskopf and Medina, p. 11 supra 18124 Ibid., p.11125 Shavell, p.1. 126 Hoffman v. Red Owl Stores, Inc., 26 Wis.2d 683, 133 N.W.2d 267.

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Barnett mandates a disclosure exemption for information contributing to allocative efficiency, he is

simultaneously granting a quasi-property right to the information-possessor and denying the materiality of

that information to the consent of the opposing party. In light of the all-or-nothing, zero-sum balance

between these two weighty considerations, it is clear why development of a contiguously normative and

successfully positive framework for this duty has been elusive.

An additional tension characterizing this disclosure puzzle is that between opposing efficiency

considerations, that of information-sharing and information-production. Milton Friedman argues that an oft-

overlooked pre-condition for efficient market interaction and contractual relations is that both parties are

fully informed127 (information-sharing), while in spite of the departure from the caveat emptor doctrine,

modern contract theorists opt to sacrifice full disclosure for the sake of information-production. One may

categorize this tension as a subset of the near-omnipresent legal expostulation regarding distributive justice

and productive efficiency.128 All of the economic theories discussed give some preference to information-

production, although Eisenberg's theory places distributive concerns more prominently, in his recognition of

and compensation for a number of power asymmetries between contracting parties.129 Despite the prima

facie perception that a 'fairness' theory would clearly lean towards information-sharing, it is unclear which

direction Scheppele's theory favors, owing to the muddled boundary between deep and shallow secrets.130

Within the realm of information-production lies another dispute, this time over the type of information

whose revelation should be encouraged, between that which aspires to allocative efficacy and that

encouraging productive efficiency. Eisenberg, unifying both approaches while clearly leaning towards the

latter, ultimately forges a higher standard for non-disclosure.

Eisenberg’s technique of combining a number of different disclosure standards is supported by the

positive law. When combined together to form a higher standard, disclosure theories have had greater

success in predicting case outcomes, as seen in Krawiec and Zeiler’s statistical study. It found that while

Kronman's and Scheppele's theories are separately insignificant indicators of case outcomes, when

synthesized they become significant predictors of juridical decisions.131

In an attempt to seek out the degree to which modern disclosure theories correspond with the

positive law, the trivial ‘base case’ was identified based on the assumption that the clarity of a theory’s

assessment of a case should be a significant factor, due to the ambiguous nature of legal distinctions.

Accordingly, in order to measure this criterion, it is desirable to measure potentially unequivocal theories

against a more trivial body of cases, in which the resounding clarity of the theory’s assessment should be

expected, since the answer is well-established within the positive law. When choosing the ‘base case,’ it was

important that the case appear frequently, so as not to discount any theory failing to account for a rare yet

overt case. 127 Eisenberg, p.7128 In other words, making the pie larger vs. dividing it more equally.129 Eisenberg, p. 28. He identifies psychological asymmetries (loss aversion), asymmetry of potential harm, in addition to asymmetry of access as justifications for requiring disclosure.130 As explained in Chapter II, Scheppele's theory is almost forced to walk the line between these two interests, since any leanings towards one of the interests may compromise the theoretical basis of her argument. 131 Krawiec and Zeiler, p.63

19

In analyzing each theory’s evaluation of the ‘base case,’ only Scheppele’s theory provides a entirely

lucid answer. The information in the ‘base case’ is patently a “shallow secret,” since no potential buyer

would ever assume without some substantiation that a particular seller’s price was the lowest. While

Eisenberg, using Kronman's criterion, considered market information to be usually deliberately acquired,

Kronman’s answer to the ‘base case’ seems unclear when viewed under scrutiny. Information regarding a

competitor’s prices may be achieved adventitiously simply by virtue of a seller’s presence within the

marketplace. Furthermore, his theory does not withstand the ‘clarity’ criterion, as the ‘base case’ does

epitomize deliberately acquired information.

Barnett’s assessment too fails to provide a clear answer to the ‘base case,’ as the data involved does

not clearly contribute to allocative efficiency. Information regarding a competitor’s prices may not affect the

market since the competitor himself has likely already conducted transactions utilizing this information, thus

already affecting, if at all, the allocation of resources. The ‘consequential’ approaches utterly flounder in

their assessment of the ‘base case,’ as information about a competitor’s prices does not bear social value

according to their criterion. Posner’s approach leads to conflicting answers. If analyzed according to the

buyer’s cost of acquisition, it is unclear whether the data in the ‘base case’ should be disclosed, since it is

dubious whether a seller could acquire the information at a significantly lower cost than a potential buyer. If

analyzed according to the related criterion Posner cites, allocation of risk, the consensus regarding the ‘base

case’ may evidence the buyer’s assumption of the risk regarding the information involved.

Almost paradoxically, the highly comprehensive economic approach developed by Prof. Eisenberg

seems to reach the ‘wrong answer’ after clearly and correctly assessing the ‘base case’ using three different

criteria in his theory. Using the broad consensus for a disclosure exemption as evidence of a ‘common trade

practice’ or ‘contractual provision,’ and highlighting the symmetry between buyer and seller regarding

market information, he reaches the desired assessment in a resounding fashion. However, he later adds two

harm criterions which potentially justify the wrong answer, and claims that non-disclosure of market

information will have no significant effect on the market. In order to interpret his theory in a consistent

manner, it follows that his final commentary on the substantive asymmetry between buyer and seller

regarding market information and the negligible effects of such a disclosure policy may be purely normative

commentary, and not a prediction of the positive law. In this case, his assessment clearly arrives at the right

answer, but is not normatively based. He essentially uses the broad consensus regarding the ‘base case’ as

an explanation as to why it exists.

To conclude, as an ‘easy’ case, the ‘base case’ is fundamentally limited in the scope of its

explanatory power. It cannot reveal the answers to difficult disclosure cases, the central theoretical emphasis

of modern disclosure theories. However, it does serve as a sieve regarding the fundamental conclusions of

these theories, sifting out those theories who fail to uniquely account for the positive law’s answer to this

common disclosure question.

Since all theories except for Scheppele’s fail to accurately assess the ‘base case’ using its own

normative terms, it may imply that the ‘equal access’ criterion is a better candidate than an efficiency-based

20

distinction for characterizing a general rule of disclosure. This implication would, however, in no way deny

efficiency considerations a place within a comprehensive disclosure theory, but it would make them the

exception, used for solving hard cases, rather than the general rule.132

132 A number of essential disclosure issues unfortunately do not relate to the 'base case' and were accordingly omitted from this paper. They include: (1) The nature of the relationship between the two contracting parties; (2) The status of the information in question as being objective or subjective; (3) The degree to which the non-disclosure is active, i.e. whether the non-disclosure may be considered misrepresentation or fraud.

21

Works Cited

George Akerlof, The Market for “Lemons:” Quality Uncertainty and the Market Mechanism, 84 Q. J. Econ 488 (1970).

Randy E. Barnett, Rational Bargaining Theory and Contract: Default Rules, Hypothetical Consent, the Duty to Disclose, and Fraud, 15 Harv. J. L. & Pub. Policy 783 (1992).

R.L. Birmingham, The Duty to Disclose and the Prisoner's Dilemma: Laidlaw v. Organ, Will. & Mary L. Rev. 29.

Anthony Duggan, Michael Bryan, Frances Hanks, Contractual Non-Disclosure (Melbourne: Longman Press, 1994)

Jules L. Coleman, Douglas D. Heckathorn & Steven M. Maser, A Bargaining Theory Approach to Default Provisions and Disclosure Rules in Contract Law, 12 Harv. J. L. & Pub. Policy (1989).

Robert Cooter and Thomas Ulen, The Economics of Contract Law (1986).

Richard Craswell, Taking Information Seriously: Misrepresentation and Non-disclosure in Contract Law and Elsewhere, 92 Va. L. Rev. (2006).

Deborah A. DeMott, Do You Have the Right to Remain Silent?: Duties of Disclosure in Business Transactions, 19 Del. J. Corp. L. 65 (1994).

Frank. H. Easterbrook, Insider Trading, Secret Agents, Evidentiary Privileges and the Production of Information, Supreme Court Review 11 (1981).

Melvin A. Eisenberg, Disclosure in Contract Law, 91 Cal L. Rev. 1645 (2003).

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