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Friday, April 27, 2007

Why not Enforce "Penalty" Liquidated Damages Clauses?

Thanks to the whole Prawfs gang for the opportunity to guest blog. Here is a thought I had after teaching contract remedies last year:

Along with most of the law and economics crew, I've always been confused by the common law's hostility to liquidated damages that function as penalties. (For those unfamiliar with what this means: if a contract specifies a specific amount of damages in the event of a breach and the contract is breached, courts will refuse to award the specified amount of damages if the specified amount is necessarily higher than the actual damages in all cases. See Lake River v. Carborundum, 769 F.2d 1284 (1985).)

The argument against non-enforcement of penalty liquidated damages is relatively straightforward-- why should a court insert its judgment about actual damages when knowledgeable parties have settled on an explicit measure for damages? Instead, the court should just enforce the liquidated damages the parties specified. When teaching liquidated damages to my contracts class, I was short on arguments defending the common law practice of non-enforcement.

Recently, however, I've come to think that the issue is not all that different from the debate about specific performance. The case for specific performance sounds a lot like the case against penalty damages. If a promisor agreed to do something and nothing has changed, then why not make the promisor perform as promised rather than attempting to guess at the appropriate level of damages.   

This is a good argument for specific performance, but there is also a case against specific performance. The concern is that promisees will request specific performance even when the value of performance is less than its cost, hoping to extract some extra money from the promisor. In turn, the promisor may take excess precautions to avoid being placed in a position where the promisee can obtain supercompensatory damages. In total, this leads to overperformance of contracts.

As with specific performance, so too with liquidated damages. If courts always enforced liquidated damages clauses, then liquidated damages clauses would have an added element of risk-- that the promisee would spot a trivial breach and sue for liquidated damages greatly in excess of actual damages, leading to overprecuations by the promisor and overperformance.  Anticipating this, parties to a transaction might stop using liquidated damages clauses in the first place.

Alternatively, the parties could draft more complex graduated liquidated damages clauses, with small breaches receiving correspondingly small damages. This would have the benefit of reducing the probability of overperformance, but it would also undermine part of the purpose of liquidated damages clauses-- to make life simple.

I'm not sure that this concern about potentially penal liquidated damages outweighs the argument for enforcement of all liquidated damages clauses-- just as I'm not sure that the argument against specific performance outweighs the argument for specific performance. (Indeed, I've previously written in favor of specific performance.) Nontheless, this strikes me as an argument worth considering when thinking about enforcement of penalty damages.  I'm willing to bet that this has been said before, but it strikes me as an argument worth noting because it is not fleshed out in the casebooks to the same degree as it is in the specific performance context.

Posted by Yair Listokin on April 27, 2007 at 11:14 AM in Teaching Law | Permalink

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Despite going out of his way to show that the rule makes no sense in Lake River, Judge Posner applied the law of Illinois to deemed the L.D. provision a penalty. I wrote a short piece on the case that is included in the teacher's manual to White and Frier's The Modern Law of Contracts. Here's a redacted excerpt from my note:

* * *

Based on an article written some years later, there is an argument Judge Posner was not so much concerned about the issue of liquidated damages, but contract drafting that so poorly reflected the business realities as to appear to be a mistake. See Richard A. Posner, The Law and Economics of Contract Interpretation [Texas Law Review citation]. Judge Posner’s comments on mistake seemed to reflect situations like Lake River: "What the cases that allow rescission on the ground of 'mutual mistake' are really about is a demonstrable real-world fact that makes a semantically unproblematic contract either insolubly ambiguous or nonsensical." Judge Posner contends there is a functional relationship between the cost of good drafting (consistent with rational actor theory) and the later cost (including the use of the courts) of dealing with ambiguous or erroneous drafting. Thus, sophisticated parties who assert a badly drafted clause ought to lose. Is it possible Judge Posner viewed not so much as the contract clause having constituted a penalty, but as having been a badly drafted penalty (i.e., potentially inefficient and not commonsensical - see below).

Judge Posner often equates efficiency with common sense; indeed that is the basis for his jurisprudence of pragmatism. Most people don't enter into one-sided agreements. If the interpretation of an agreement makes it one-sided, that interpretation is probably wrong. "That would be a reason - call it common sense or, if some explicit economic reasoning is employed, the promotion of efficiency - for the judge to choose the other interpretation." Indeed, a bit later in the article Judge Posner quotes his own cases to the effect that a contract will not be interpreted literally if doing so would produce absurd results, in the sense of results that the parties, presumed to be rational persons pursuing rational ends, are unlikely to have presumed to seek. It is clear that Judge Posner did not think the clause in Lake River was commonsensical. He demonstrates that if the costs of performing were avoided, Lake River was actually far better off in the circumstance of a breach. Based on the discussion above regarding fixed and variable costs [n.b. not included here], did Judge Posner have a legitimate basis for this view?

It seems clear as well that it was not the legal theory of liquidated damages but his view of what looked like a nonsensical contract that drove Judge Posner’s opinion. Later in the opinion, he rejects an analogy to take-or-pay contracts, which are common in the supply of raw materials to utilities, and often enforced. There again his view of the fixed versus variable costs was critical; he distinguishing take or pay contracts in which there is a huge front end investment compared to the small ongoing variable cost. In his article, Judge Posner stated, "businessmen are not literalists. They do not have the lawyer's exaggerated respect for the written word and thus do not expect bizarre consequences to follow from mistakes in drafting. . . .Businessman [sic] would, I am speculating, like judges to resolve interpretative issues the way a reasonable businessman would."

If the parties in fact offered up penalty versus liquidated damages as the issue, did it provide Judge Posner with the most pragmatic route to where he likely believed reasonable businessmen would have wanted this issue to land - on a more traditional calculation of expectation damages, measured by the lost investment plus the lost profits? Without any evidence to support mutual mistake, he would have been rewriting the unambiguous words of the contract. So he deemed it a penalty and his view of the common sense result prevailed. Is this an appropriate outcome? Do you think businesspeople would rather have their language interpreted literally or according to a judge’s view of what a reasonable business outcome should be? Does it seem just as plausible that Carborundum was trying to weasel out of a clear agreement to cover allocated fixed costs in addition to cost of the bagging machine, and that Lake River’s lawyers did a poor job explaining there was no windfall? Is Lake River a better case for a “four-corners” approach or a contextual approach to contract?

Posted by: Jeff Lipshaw | Apr 27, 2007 3:09:06 PM

Interesting; you could add the rule awarding restitution for the value of part performance by a breacher to the list too, as well as Jacob & Youngs and the correct calculation of expectation damages.

BTW, unless I'm missing something, the argument for specific performance sounds like the argument for penalty damages, not against.

Posted by: Bruce Boyden | Apr 27, 2007 2:31:30 PM

Lake River is one of the examples I use in my contracts course to explain why certain rules that might make sense in type 1 and type 2 contracts -- contracts between natural persons (type 1) and contracts between a natural person and an organization or firm (type 2) -- can make little sense in type 3 contracts, contracts between firms. Indeed, Posner goes out of his way to explain why the rule makes no sense in the Lake River-Carborundum context in particular: because they are both sophisticated entities. Thus, a contract law tailored to those capable of assessing their own risks and self-interest (i.e., a law governing type 3 contracts exclusively) might very well do away with the rule against penalty clauses (or might not, as you argue). But the core justification for the rule against penalty clauses seems to me to derive from concerns we have in type 1 and type 2 contracts about individuals being unable to ascertain their risk. This is, of course, why L&E and other cotract theorists so often talk past one another: L&E-types are always assuming we should have a contract law for firms exclusively. I make a version of this argument here:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=762905

Posted by: Ethan Leib | Apr 27, 2007 11:52:48 AM

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