Damages

Contract

Contract historically has been one of the central concepts, if not the central concept, defining the legal structure of liberal Western society. A variety of developments, however, have led to uncertainty about the meaning, nature, and scope of contractual relationships. The classical definition of contract, stated in perhaps its clearest form by Oliver Wendell Holmes, Jr., in the late nineteenth century, has a considerable continuing influence on the general orientation of the legal system, even as it corresponds less and less with the way agreements are actually made and enforced.

A critique of the law of liquidated damages is important both for reasons of praxis and theory. From a practical perspective, such liquidated damages clauses are commonly found in many types of contracts, from employment to construction contracts. A number of reasons exist for the popularity of these clauses. First, because of the fears and costs associated with litigation, parties who draft such clauses do so in the hopes that they will preclude the need for litigation. At the very least, a liquidated damages clause may encourage the parties to settle before the trial phase or to provide some evidentiary value at trial. Parties have also used liquidated damages clauses as a mechanism for retaining monies that have been deposited or paid under the contract. Finally, a party concerned foremost with performance, especially a timely performance, may use such a clause in the hope that it will provide a further inducement for performance.

The idiosyncratic uniqueness of the performance can only be protected by the enforcement of the penalty. Also, the non-breaching party deprived of a specific performance remedy should not be forced into litigation in order to quantify damages. In the civil law system, where specific performance is viewed as a preferred remedy, the non-breaching party has the option of avoiding the vagaries and uncertainty of quantifying damages. Contractual devices, such as liquidated damages, offer greater remedial flexibility in the common law's anti-specific performance remedy structure. It can be viewed as a semi-legal substitute for the equitable remedy of specific performance. To the extent that the liquidated damages clause maintains the contractual relationship, it acts as a self-help form of specific performance. If the penalty is efficient and results in a breach, then the supracompensatory nature of the penalty can be n as compensation for the non-breaching party's inability to demand specific performance.

The second perspective from which to review this area of contract law is the theoretical. The law of liquidated damages is unique within the common law of contracts because it overtly affronts freedom of contract. The freedom of parties to structure their own agreement is universally acknowledged to be at the heart of the common law of contracts. In contrast to this freedom of contract, the limited enforcement of liquidated damages clauses, in which parties have agreed to a specified measure of damages in the event of breach, is a long recognized exception. The non-enforcement of liquidated or stipulated damages clauses, those that are classified as excessive penalties, is justified on public policy and fairness grounds. But why are liquidated damages clauses singled-out for specialized scrutiny? This scrutiny is especially questionable in the cases where such clauses are a clear expression of the parties' intentions. The law and economics literature is rich in analysis regarding the efficiency of enforcing or not enforcing liquidated damages clauses. General economic theory suggests that any express agreement between rational contracting parties should be fully enforced. However, an efficient breach argument can be made in favor of the non-enforcement of penalties, namely, that a party may be deterred from an otherwise efficient breach because of the punitive nature of the stipulated damages.

The law of liquidated damages embodies the language of dichotomy. The law is characterized by the great divide between enforceable liquidated damages clauses and unenforceable penalties. Parties may agree to stipulated damages but only at an amount that is considered reasonable. An amount above anticipated or actual compensatory damages is presumed to be a penalty, and the common law abhors penalties. The incongruity between freedom of contract principles and the non-enforcement of penalty clauses has generated an extensive body of scholarly commentary. The most recent analysis has evolved from the law and economics school. It is to the law and economics literature that this Article will turn in judging the rationality of the just compensation principle as it relates to the law of liquidated damages.

A theoretical dichotomy has developed among law and economics scholars in the critiquing of the current law of liquidated damages. Arguments have been spun criticizing the non-enforcement of liquidated damages clauses as the inefficient preemption of private bargaining. Professors Goetz and Scott formed their critique in favor of the enforcement of penalty clauses. They used a model of the most efficient insurer to argue that the performing party to the contract is the best insurer. A penalty clause is the insurance policy for which the other party is willing to pay a premium. In the alternative, when a penalty clause is not included, the non-breaching party will be forced to take inefficient precautions (such as third-party insurance) in order to insure against breach. It would be more efficient to enforce the penalty clause than to force the parties to take other precautions or use other remedies. Other scholars have argued that the current law is efficient as currently constituted. In short, they claim that penalties are inefficient because they deter efficient breach. Clarkson, Miller, and Muffs have argued that the non-enforcement of penalty clauses is indeed an efficient rule of contract law. Their primary argument is that penalty clauses, if enforced, produce an incentive for the non-performing party to induce a breach by the performing party. In short, the penalty clause provides opportunism for the non-breaching party. However, unlike the opportunism that supports efficient breach theory, non-breaching party opportunism is not conducive to creating additional societal wealth or utility. This Article will argue that the current dichotomies are overly simplistic. It will argue that penalties may be either efficient or inefficient. Therefore, a law that holds all penalties as per se unenforceable is necessarily flawed. A theory of efficient penalty recognizes that the presumption in favor of the enforcement of liquidated damages clauses should be expanded to include liquidated damages qua penalties. Only liquidated damages clauses that are products of inefficient