All Commentary
Thursday, September 1, 1994

Economic Illiteracy Makes Bad Law

A Court Finds a Salesman's Contract "Unconscionable"

Mr. Pulliam is an attorney in private practice in San Diego.

The great jurist Oliver Wendell Holmes once said, speaking about judicial decisions, that hard cases make bad law.[1] This may often be true, but that is not the only explanation for bad judicial decisions. There are other reasons why judges sometimes get things wrong—they may intend to reach a desired result, and bend the law to get there; or the lawyers for the parties may do a poor job arguing the case; or, more typically, judges simply make mistakes. In a case with potentially far-reaching implications decided by the California Court of Appeal for the Fourth Appellate District in San Diego, the court made a serious mistake; the reason was economic illiteracy. The case, John Ellis v. McKinnon Broadcasting Co.,[2] was a dispute between a TV station and a former employee of the station, an advertising salesman, over commissions that the salesman claimed were owed him. The salesman voluntarily resigned from the station and sued for a 20 percent commission on ads he had sold prior to his resignation but that were not paid for until after he left. The salesman had a written contract with the station that specified that “[n]o commissions will be paid to the Employee on advertising fees received by the station after the Employee’s final date of actual employment.”

There was no dispute that the salesman had received all salary he was due and full commissions on all ads that had been paid for before his last day of work. Because the contract specifically said the salesman was not entitled to commissions on revenues received after termination, this would seem to be an easy case. In fact, the salesman’s lawsuit would seem to be frivolous on its face. That is what the trial court concluded by ruling in favor of the station. Wrong. Welcome to California, where no claim is frivolous and where easy cases routinely make bad law. In a unanimous decision, the Court of Appeal ruled in favor of the salesman and ordered the station to pay him $19,768.12 plus his costs on appeal.

How can such an obviously incorrect decision be explained? The station argued that the contract was not ambiguous. The Court of Appeal agreed: The contract “clearly purports to deny [the salesman] any commissions on advertising fees paid to [the station] after the termination of his employment.” The salesman was not a minor, nor was he incompetent (due to insanity or illness) to enter into a contract. The station did not defraud him or force him to sign the contract under duress. He signed the unambiguous contract knowingly, voluntarily, and, in the words of the court, “without any objection or attempting to modify it.” How, then, could the salesman possibly win this case?

The short answer is that the court refused to enforce the contract because it found the unambiguous denial of commissions on post-termination revenues to be “unconscionable.” The real answer is that the court failed to apprehend the economic principles involved in the case. The court found that the contract was “unconscionable” for several reasons: the salesman did not read it carefully at the time he signed it; the contract was in a standard pre-printed form used by the station; the parties had “unequal bargaining power” because the salesman was an individual and the station was a corporation; and the challenged provision of the contract was, in the court’s view, unreasonable. (I am not making this up.)

The court’s decision reveals a disturbing lack of familiarity with basic economic concepts—economic illiteracy—on both a practical and a philosophical level. On a practical level, the court has undermined the certainty and predictability on which business, trade, and commerce depend. Under this decision, all contracts, no matter how clear, express and voluntary, may be challenged after the fact if one party fails to read it carefully (or claims not to have read it). Careless and sloppy behavior is encouraged, even rewarded. The courts will become an arbiter after the fact of the “reasonableness” of terms previously agreed to and relied upon by the parties. All commercial transactions—and many transactions between individuals—depend on contracts, and the expectation that agreements, once made, will be enforced. A deal must be a deal. The decision in this case invites chaos in California’s business community, not to mention needless litigation. A legal system justly viewed as contributing to an unfavorable business environment has just made things worse.

On a philosophical level, the decision is even more troubling. Our nation was founded on certain political and economic principles, including individual liberty, private property, and limited government. A free-market economy—recall it what you like, capitalism, the free enterprise system, or freedom of contract—is an indispensable requirement for personal autonomy and individual liberty. When relationships among people are formed voluntarily, in the absence of fraud or duress, both economic efficiency (or “consumer welfare”) and personal freedom are maximized. Accordingly, one of the principal responsibilities of government is the enforcement of contracts. The refusal of government to enforce a valid contract is an interference with and violation of the most fundamental individual liberty citizens have in a free society—the right to determine their relationships on mutually agreeable terms.

The court’s opinion not only refuses to enforce an unambiguous contract between competent parties, it does so for dubious reasons. There is no such thing as “unequal bargaining power” among consenting adults. In order for a voluntary exchange to take place, both parties must be willing to trade something of value to the other. By definition, both parties to a contract believe they will be better off as a result. This principle of voluntary exchange is inherent in every economic transaction we enter into. The allocation of all goods and services in a free economy is determined by the desires expressed by willing buyers and sellers. When a consumer enters a Sears store, or a K-Mart, or a Wal-Mart, his “bargaining power” is the same as it would be at a swap meet, a yard sale, or a Middle Eastern market.

The consumer is not required to buy anything, and will not purchase an item unless he regards it as being more valuable than the amount of money being charged for it. Whether that price is established unilaterally by the seller or as the result of negotiation with the buyer is irrelevant. There will be no agreement unless the price is acceptable to both parties. Whether the buyer is a corporation or an individual is also irrelevant. Absent fraud or duress, all voluntary economic exchanges are equally con-sensual. As recent events have illustrated, even the mightiest Fortune 500 corporation (IBM and General Motors come to mind) cannot force consumers to buy their products if better or cheaper alternatives exist in the market, or if consumers simply don’t want them.

At the outset of the employment relationship, the TV station in the Ellis case was not legally required to pay commissions to the salesman. It could have paid only a salary. The station was not required to pay a 20 percent commission; it could have offered a 5 percent, or 10 percent, or 15 percent commission instead. Of the many (indeed, infinite) permutations of conceivable terms of employment, the station offered a particular formula of compensation consisting of a specified salary and a specified commission on specified sales. It is not the business of the government (and courts are just another branch of government) to censor terms of voluntary exchanges or to review their “reasonableness.” The salesman agreed to the particular package of compensation and benefits offered by the station. The terms were explicit and unambiguous. If the salesman didn’t like the terms, he was free to say no, to find another job. But he did not. He entered into a contract with the station. After the fact, he went to court and asked the government to require the station to pay more than it had agreed to pay. The court obliged, reciting a litany of nonsensical reasons. The case was an easy one, yet it produced a bad decision. And while the amount in dispute in Ellis was relatively small, the court’s erroneous reasoning will hold sway in other, more substantial cases. It is a sad commentary on our judicial system that basic economic concepts are so poorly understood. As a consequence, it does not take a hard case to make bad law; for economic illiterates, any case will do.

Federal appeals court Judge Alex Kozinski once described a similarly misguided decision of the California Supreme Court as “more resembl[ing] a brick thrown from a third story window than a rule of law.”[3] To the TV station in this case—who, after winning in the trial court and incurring attorneys’ fees to defend the appeal, is ordered to pay almost $20,000 in commissions that were never bargained for, upon the basis of an argument that was never made by the appellant—the decision in Ellis is more like a drive-by shooting. Unfortunately, while the TV station may be the random victim, the Ellis decision reflects more than an isolated lapse by a particular panel of appellate judges in California. There is a disturbing phenomenon underway across the nation. At the urging of litigants (both individuals and corporations), courts are increasingly intruding into business and personal relationships. Scholars such as Peter Huber and Walter Olson have documented the “litigation explosion” in America and the accompanying changes in the nation’s legal system.

Judge Kozinski, one of the few jurists to decry these changes, has pointed out that the trend toward intrusion into contractual relationships “generates serious costs and uncertainties, trivializes the law, and denies individuals the autonomy of adjusting mutual rights and responsibilities through voluntary contractual agreement.”[4] According to Judge Kozinski, the result is that “both the commercial world and the courts are needlessly burdened: The parties are hamstrung in developing binding agreements by the absence of clear legal principles; overburdened courts must adjudicate disputes that are incapable of settlement because no one can predict how—or even by what standard—they will be decided.”[5] The arrogance of judges who wish to rewrite parties’ contracts, with no apparent understanding of the business world in which they interlope, is, in the words of Judge Kozinski,

symptomatic of a more insidious disease: the novel belief that any problem can be ameliorated if only a court gets involved. Not so. Courts are slow, clumsy, heavy-handed institutions, ill-suited to oversee the negotiations between corporations . . . .

Moreover, because litigation is costly, time-consuming and risky, judicial meddling in many business deals imposes onerous burdens. It wasn’t so long ago that being sued (or suing) was an unthinkable event for many small and medium-sized businesses. Today, legal expenses are a standard and often uncontrollable item in every business’s budget, diverting resources from more productive areas of entrepreneurship. Nor can commercial enterprises be expected to flourish in a legal atmosphere where every move, every innovation, every business decision must be hedged against the risk of exotic new causes of action and incalculable damages.[6]

“Progressive” judges willing to interfere with the contractual arrangements of others, aside from creating obstacles to commerce, are engaged in an odd exercise of historical atavism. One of the defining characteristics of Western society, and the essence of its emergence from medieval feudalism, is the movement from status to contract. Friedrich Hayek wrote that “the conception of status, of an assigned place that each individual occupies in society, corresponds • . . to a state in which rules . . . single out particular persons or groups and confer upon them special rights and duties. The emphasis on contract as the opposite of status is . . . that the law supplies [the instrument] to the individual to shape his own position.”[7] As a matter of history, the simultaneous development of contract principles and a market economy liberated mankind from the squalor and oppression of rigidly hierarchial, status-based feudal systems that had prevailed in Europe for centuries. In the name of protecting individual rights, modern-day judges spurn the freedom of contract that is essential to liberty in favor of status-based classifications that are incompatible with liberty.

This is the supreme irony of our legal system’s infatuation with itself and its presumed ability to improve upon the spontaneous, private ordering of the market. That grand conceit, like the conceit of all government regulators, is just another step down the road to serfdom. As Judge Kozinski has warned, the overreaching of government officials into private relationships should be viewed with no less suspicion just because they happen to wear robes.[8] []

  1.   “Great cases, like hard cases, make bad law” (dissenting opinion in Northern Securities Company v. United States, 193 U.S. 197, 400 [1904]).
  2.   18 Cid. App. 4th 1796 (1993).
  3.   Oil America, Inc. v. Microtech International, Inc. 872 F.2d 312, 315 (9th Cir. 1989) (Kozinski, J., concurring).
  4.   1d.
  5.   1d.
  6.   ld. at 316.
  7.   Friedrich Hayek, The Constitution of Liberty (Chicago: University of Chicago, 1960), p. 145.
  8.   872 F.2d at 316.