A Commitment Mechanism to Eliminate Willful Contract Litigation

57 Pages Posted: 26 Jul 2014 Last revised: 14 Sep 2014

See all articles by Osnat Jacobi

Osnat Jacobi

Harvard Law School - Graduate Program; Bar-Ilan University - Department of Economics; Netanya academic college

Noam Sher

Ono Academic College - Faculty of Law

Date Written: September 2014


This paper concerns companies that sell commodities and are in their initial stages of formation and growth. Such companies will often face severe difficulties due to the banking system's unwillingness to finance their activities before they are able to develop sufficient credit histories. When faced with a loss contract, such a company may prefer to breach and litigate simply in order to gain time before having to pay off its debt, thereby preventing immediate insolvency. We have designed a new financial tool to eliminate this incentive to willfully litigate. Under this mechanism, the seller undertakes an obligation to pay a bank the amount of the buyer's damages if the seller does not deliver the good on delivery day in accordance with the contract and law. The bank, in turn, undertakes to pay the buyer the amount of her damages if received by the bank. The effect of this mechanism is to shift the buyer's entitlement to the bank. This increases the seller's cost of willful litigation: if the seller chooses to breach he will prefer paying the buyer's damages to the bank in order to avoid any indication of default on the bank's records, since such an indication will affect his credit rating and access to financial markets in the future. In addition, the mechanism gives the seller an incentive to breach the contract if and only if the contract becomes ex-post inefficient. We also demonstrate ex-ante benefits from the mechanism: by eliminating the risk of willful litigation, established buyers may be willing to raise the contract price, thereby increasing the probability of newcomers’ survival. The mechanism also enables the banking system to screen new companies according to their quality, and use their contracts as collateral. Ultimately, this can result in the newcomer achieving financial stability earlier.

Keywords: willful litigation, breach of conract, small business finance, UCC

JEL Classification: G20, G30, K12, K20, K41

Suggested Citation

Jacobi, Osnat and Sher, Noam, A Commitment Mechanism to Eliminate Willful Contract Litigation (September 2014). Available at SSRN: https://ssrn.com/abstract=2471438 or http://dx.doi.org/10.2139/ssrn.2471438

Osnat Jacobi

Harvard Law School - Graduate Program ( email )

1563 Massachusetts Avenue
Cambridge, MA 02138
United States

Bar-Ilan University - Department of Economics ( email )

Department of Economics
52900 Ramat-Gan

Netanya academic college ( email )


Noam Sher (Contact Author)

Ono Academic College - Faculty of Law ( email )

104 Zahal St.
Kiryat Ono, 55000
972-52-6309102 (Phone)

HOME PAGE: http://www.ono.ac.il

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