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Penalty Clauses and Liquidated Damages

Penalty Clauses and Liquidated Damages

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Published by: legalmatters on Aug 11, 2007
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141
4610P
ENALTY
C
LAUSES
A
ND
L
IQUIDATED
D
AMAGES
Gerrit De Geest
Professor at the University of Ghent  Researcher at the Economic Institute/CIAV, Utrecht University
Filip Wuyts, M.Sc.
© Copyright 1999 Gerrit De Geest and Filip Wuyts
Abstract
This chapter surveys the economic literature on stipulated damages. In theliterature there seems to be a consensus that liquidated and underliquidateddamages should be respected. Liquidated damages can be a rational option,especially if parties have more information about the possible losses than judges. Underliquidated damages may can serve as a technique to let partiesshare the risk of increased production costs.Penalty clauses, on the other hand, have been the subject of a fiercecontroversy for a long time. Most authors seem to defend the prohibition of penalty clauses. Yet it can be argued that they should be allowed under someconditions.
 JEL classification
: K12
Keywords
: Stipulated Damages, Underliquidated Damages, Remedies,Breach of Contract
1. Introduction
Sometimes parties to a contract ex ante agree upon how much compensationwill have to be paid should one of them breach the contract. These stipulateddamages are called ‘liquidated damages’ when they are
ex ante
reasonableestimations of the true losses. They are called
<
underliquidated damages’when they are meant to be undercompensatory and ‘penalty clauses’ whenthey are deliberately overcompensatory in order to create an additionalsanction (‘penalty’). In common law penalty clauses are forbidden accordingto the ‘penalty doctrine’. Liquidated and underliquidated damages on theother hand are allowed.This regulation of penalty clauses has received so much attention in thelaw and economics literature that it deserves a separate section. The firstanalyses did indeed not make clear why common law restricts the freedom of 
 
142
Penalty Clauses and Liquidated Damages
4610contracting parties in this way. In 1979 Posner (1979, p. 290) described thepenalty doctrine as ‘a major unexplained puzzle in the economic theory of law’. The penalty doctrine seemed to form an important exception toPosner’s general thesis that common law is efficient.Before starting to review the literature it might be helpful to payattention to the precise definition of the borderlines between penalty clausesand liquidated damages.Rea (1984a) has argued that much of the confusion around the penaltydoctrine occurs because of the failure to distinguish
ex ante
and
ex post 
valuation of losses. It is not because stipulated damages
ex post 
turn out tobe overcompensatory that they will be considered penalty clauses byAmerican courts. American courts only check whether the clauses arereasonable
ex ante
. When clauses are
ex ante
reasonable estimations of thetrue losses, or to put it differently, when clauses reflect the expected losses,they will be enforced.In addition, liquidated damages are meant to compensate fully for losses,including subjective and other hard to prove losses. It is possible that courtsmistakenly consider liquidated damages to be penalty clauses because theyunderestimate subjective costs. Yet, from an analytical point of view theseclauses should be seen as liquidated damages. An early article of Goetz andScott (1977) can serve as an illustration of this confusion. Goetz and Scottargued that a penalty clause is often just a way for a contracting party toinsure itself against idiosyncratic harm or otherwise uncompensateddamages. They give the example of a group of alumni who attach anenormous subjective value to attending a baseball game of their collegeteam. Therefore, they stipulate in the contract with the bus driver that thelatter wil have to pay a high amount of damages in case he arrives late. Thisamount is high but just reflects their true subjective losses. Moreover, thepromisor will very often be a better insurer than a traditional third partyinsurer. This argument, however, is in fact just a plea for respectingliquidated damage clauses and not necessarily an argument forsupracompensatory penalty clauses.
2.
 
Liquidated Damages, Penalty Clauses and Underliquidated Damagesas Compared to Other Remedies
Many arguments for or against penalty clauses hold for other, less contestedremedies as well. Therefore, it is important to situate these sanctions withinthe complete set of contract remedies, including the reliance measure, theexpectation measure and specific performance.
 
4610
Penalty Clauses and Liquidated Damages
143At first sight, liquidated damages seem to be equivalent to theexpectation measure. Liquidated damages are meant to fully compensate thepromisee and ‘fully’ includes the expected profits (only in cases were theexpected profits are compensated, the promisee is really indifferent withregard to performance or breach). The major difference seems to lie in thefact that liquidated damages are calculated
ex ante
(at the time of contracting) while the expectation damages are calculated or madeoperational
ex post 
(after breaching). One major disadvantage of expectationdamages that is that they discourage efficient entering into contracts (seeChapter 4600), which holds for liquidated damages as well. To put itdifferently, if sellers demand liquidated damages in case of breach, fewerbuyers than optimal will sign the contract.With respect to breaching decisions, however, there is a difference. Theexpectation measure leads to efficient breaching (Birmingham, 1970;Shavell, 1980). Liquidated damages, however, are determined
ex ante
, so atthe time the promisor decides whether to breach or to perform, he mayalready know that the stipulated damages are over- or undercompensatory. If they are overcompensatory, the promisor might overperform; if they areundercompensatory, the promisor might overbreach. This difference may besmaller than it seems. Judges do not compensate perfectly under theexpectation measure either. If the promisor expects the judge toovercompensate he will overperform. If the promisor expects the judge toundercompensate he will overbreach.To summarize, liquidated damages may create incentives tooverperforming as well as to overbreaching. Whether incentives are worsethan under the expectation measure depends on how well judges valuate thelosses. If judges systematically and seriously undercompensate, thenliquidated damages may be the superior remedy when it comes to incentivesto breaching.Penalty clauses and specific performance have in common that both aresupracompensatory sanctions. One consequence is that both lead tooverperformance, or to put it differently, that both discourage efficientbreaches. Penalty clauses, however, award an amount of money to thepromisee, while specific performance makes the promisor perform
in natura
.At first sight this leads to an important difference: only penalty clausescreate an incentive for the promisee to induce breach. But much depends onhow specific performance works in practice. Under American law, non-performing promisors have to pay a fine on the basis of ‘contempt of court’.This fine is paid to the court so it does not alter the incentives of thepromisee But in France, Belgium and the Netherlands, specific performanceis obtained by ‘astreintes’, high amounts of money (usually for each day of 

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