Uncertainty, Reliance, Preliminary Negotiations and the Hold Up Problem

Abstract

Recently, two scholars, Alan Schwartz and Robert Scott, have cast doubt on the conventional view that courts would find liability and award reliance damages in precontractual cases that resembled the famous Hoffman v. Red Owl case. They have argued that courts deny recovery for reliance in cases involving precontractual preliminary negotiation but regularly grant reliance recovery following a preliminary agreement. They identify a pattern or sequence in which success is likely and then provide an analytical framework to justify liability. When parties reach a preliminary agreement that also includes an agreement that they both invest simultaneously and one party strategically delays investment for personal gain, the law permits the investing party to recover for reliance expenditures when the other party walks away from the deal. Courts find this sequence of events to constitute a breach of the good faith obligation that governs parties' actions in preliminary agreements.


Based on an extensive review of the reliance case law, this article suggests that contrary to the Schwartz and Scott thesis, courts do grant recovery for reliance expenditures made in precontractual preliminary negotiations resembling Hoffman even when the parties have not reached an agreement.Their willingness to do so depends on a pattern in which the promisor solicits reliance expenditures to reduce uncertainty or to hedge his bets pending the resolution of uncertainty and the promisee relies, particularly if the reliance investment takes the form of a cooperative investment rather than a selfish investment. The same risk of hold up is present whenever there is sequential investment. Thus, this article suggests that the courts are willing to grant recovery for reliance expenditures in both categories of cases (1) precontractual negotiations with no agreement and (2) reliance that follows a binding preliminary agreement to control a unified threat of opportunistic behavior and to regulate the hold up problem as a way of maximizing welfare.

Keywords: Contract law, Hoffman v. Red Owl, reliance damages, precontractual cases, preliminary agreements, hold up problem, uncertainty, recovery for reliance expenditures

JEL Classification: K10, K12