128Contract Rights and Remedies
§4.11 Penalties, Liquidated Damages, and Forfeitures
Sometimes a contract will specify the damages to be awarded if there is a breach (as with demurrage); and if the specification is a reasonable ex ante estimate of the likely damages from breach, it will be enforced under the rubric of liquidated damages even if the actual damages turn out to be much less (or more). But if it is plain from the beginning that the specification is designed to give the victim of the breach much more than he could expect actually to lose as a result of the breach, or the contract breaker to gain, then it is a penalty clause and is unenforceable. The name is well chosen; the imposition on a violator of a cost in excess of the actual damage caused by the violation is, as we shall see in Chapter 7, the essence of a penal sanction.
It might seem obvious that the law would notreand in fact it does not--enforce penalty clauses in contracts. A penalty would deter efficient as well as inefficient breaches, by making the cost of the breach to the contract breaker greater than the cost of the breach to the victim; would create bilateral-monopoly problems (how so?); and might induce the prospective victim to provoke a breach, since he would profit from it. These are good reasons for not awarding punitive damages for non-opportunistic breaches of contract (precisely the line that the law draws--punitive damages increasingly are available as a sanction for opportunistic breaches). But they are not good reasons for refusing to enforce voluntarily negotiated penalty clauses, which would not be put into contracts--not often, anywaymunless the parties expected the gains to outweigh the costs we have just identified. And they might. Suppose I know that I will honor my contracts but I find it difficult to convince others of this fact. By signing a penalty clause I communicate credible information about my own estimate of my reliability--information useful in determining on what terms to do business with me.'
Baxendale, 12 Research in Law & Econ. 9 (1989). This is an example of strategic problems in contract bargaining, a subject of particular interest to game theorists.
§4.11 1. Here is an even more dramatic example of the use of signaling to establish credibility: "The beliefs about Valhallas that reward brave soldiers killed in battle, or the hells that punish cowards, thieves and liars, were legitimated and made more credible by the royal funeral waste testifying to the leaders' belief in ail afterlife." Donald T. Campbell, Legal and Primary-Group Social Controls, 5J. Social Biological Structures 431,437 (1982).
Penalties, Liquidated Damages, and Forfeitures129
Another reason for a penalty clause is to compensate the seller for a high risk
of default. Suppose defaulting buyers will often be insolvent or otherwise unable
to cover the seller's full damages. Then the "windfall" recovery of a penalty in some
cases will, by offsetting losses incurred in others, enable sellers to take greater risks
and charge lower prices. (Where have we seen a very similar argument?) In addi-
tion, a penalty clause makes economic sense if there is some probability that a
breach will go undetected--for example, if the seller could plausibly blame the
buyer for the failure of the seller's product to perform as intended. In such a case,
without a penalty clause, the seller's expected damages liability will be less than the
buyer's actual damages and there will be too many breaches from an efficiency
standpoint.
A possible, though highly speculative, economic explanation for why courts re-
fuse to enforce penalty clauses, even when there is no reason to doubt that the
buyer accepted the clause with his eyes open, is that such clauses may lead to an
increase in the number of contract suits without any clearly offsetting gain. This
suggestion may seem paradoxical, since the heavier the sanction for a breach of
contract the less likely a breach is. But insofar as penalty clauses enable contracts
to be made by persons who are otherwise too great a default risk to be attractive
contracting parties, the increased deterrence of breach may be offset by an in- /
creased number of contracts." The "moral hazard" problem (the promisee has
more to gain from breach than from performance when there is a penalty clause
in the contract, and so he may try to provoke a breach) may also offset the effect
of a penalty clause in deterring breaches.
Moreover, a penalty clause discourages breach-averting modifications and re-
negotiations. -~ Because contract liability is strict liability, a promisor may find himself
in breach of his contract because he simply is unable, rather than merely unwilling,
to carry out his promise yet has no defense of impossibility or force majeure. Very
often in such a case the parties will agree to modify the contract, with appropriate
compensation for the promisee. Modification is less likely when there is a penalty
clause, because the clause raises the price that the promisee will demand for letting,
the promisor off the hook of the original contract. If a suit to enforce such a clause
(assuming such clauses were enforceable) were very costly, the promisee would feel
pressure to settle. But if enforcement is not costly (and why should it be if the clause
specifies a sum certain as the damages for a breach?), the promisee may hold out
for something very near the penalty and the promisor may decide he might as well
let the promisee sue. As we shall see in Chapter 21, litigation may be very costly to
the court system even when it is not to the parties wwhich is to say that parties are
able to externalize some of the costs of their litigation. To limit the externality,
courts may refuse to enforce contractual provisions that make litigation more likely, -' at least if there are no strongly offsetting efficiencies.
Determining whether a contract clause specifying the damages in the event of a breach is a penalty clause or a valid liquidated-damages clause can be tricky. "Take or pay clauses," common in the gas industry, require the purchaser either to take , the amount of gas that he has agreed to buy or to pay the price of that amount
2. A similar argument, which we'll encounter in Chapter 14, is that giving creditors better remedies in bankruptcy may actually increase the number of bankruptcies by emboldening creditors to lend money to less creditworthy borrowers.
3. Tai-Yeong Chung, On the Social Optimality of Liquidated Damage Clauses: An Economic Analysis, 8J. Law, Econ. & Organization 280 (1992); Eric L. Talley, Contract Renegotiation, Mechanism Design, and the Liquidated Damages Rule, 46 Stan. L. Rev. 1195 (1994).
130Contract Rights and Remedies
even if he takes less, rather than just to pay the seller's damages, which would be the difference between that price and the price at which the seller could resell the gas to another purchaser. Isn't that overcompensation? Not necessarily. A contract for the supply of gas often entails heavy fixed costs for the supplier, such as building a gas line to the purchaser's premises. Fixed costs by definition are invariant to the amount sold, so they are not saved by a reduction in the amount sold as a result of the buyer's breach. If fixed costs are a high percentage of total costs, the take or pay clause may not overcompensate the seller significantly.
It has been argued that there are no real penalty clauses--that viewed ex ante, and setting aside cases of fraud or duress or other pathological failures in the contracting process, a so-called penalty clanse merely compensates the promisee for an unusual risk of loss, such as an above-average likelihood of default by a high-risk promisor or the risk of ail undetectable default. 4 This is not true in the signaling case; the borrower who wants to convince the lender that he is creditworthy may agree to pay a penalty that exceeds the lender's expected costs, merely to establish the borrower's credibility. In most cases, however, it is true that the penalty clause does not overcompensate ex ante. The problems that we have discussed with penalty clauses arise because they overcompensate ex post. If those problems are litigation-engendering, they may explain, and conceivably even justify, the courts' hostility to penalty clauses.
The common law, at the same time that it was forbidding penalty clauses, allowed sellers to keep deposits and installment payments even if the result was to give the seller more money than any reasonable estimate of his damages. The Uniform Commercial Code has changed the rule with regard to sales of goods, but the older rule persists in other cases, particularly cases involving land, although with an important limitation: A mortgagee who forecloses does not thereby become the owner of the property; if the property is sold at a foreclosure sale, the mortgagor is entitled to the excess (if any) of the sale price over the amount due on the mortgage.
There are three differences between penalties and forfeitures. (1) Enforcing a forfeiture doesn't require a lawsuit; hence it is a cheaper remedy for the legal system to administer. (2) The party subject to a forfeiture is normally the payor; and the paying party is less likely to commit an involuntary breach than the performing party (why is that relevant?). (3) A forfeiture is unlikely to be ruinous, since it is limited to money already paid over by the party against whom the forfeiture is sought. Points 2 and 3 suggest that forfeitures are less likely to be the result of fraud or duress than penalties.
These differences may explain the law's preference for forfeitures over penalties but not the absolute prohibition of the latter or the growing hostility toward the former (see also §4.14 infra). One possible explanation is that since forfeitures and penalties--especially the latter--increase the risk of bankruptcy consequent on contractual default, they increase the number and hence total cost of bankruptcies (resource costs, not just pecuniary transfers); and some of that cost is external to the parties, as we shall see when we discuss bankruptcy in Chapter 14. A related but macroeconomic argument against penalty and forfeiture clauses is that if they were common, this would increase the amplitude of the business cycle by making the nulnber of bankruptcies in depressions and recessions even greater than it is. 5
4. Alan Schwartz, The Myth That Promisees Preier Supracompensatory Remedies: An Analysis of Contracting tbr Damage Measures, 100 Yale L.J. 369 (1990).
5. Daniel A. Farber, Contract Lax,' and Modern Economic Theory, 78 Nw. U.L. Rev. 303, 335 (1983).
Specific Performance131
Should the law require that every contract contain a liquidated damages clause, on the theory that the parties know better than the courts what the damages are likely to be? It should not. The costs of estimating damages may be lower when the damages arise than much earlier, when the contract is signed. And under the regime of compulsory liquidated damages clauses those costs would be incurred in every contract negotiation rather than just in the small fraction of cases in which the contract is broken and a suit ensues.