Courts
enforce ‘liquidated damages clauses’, but they refuse to enforce ‘penalty
clauses’. A liquidated damages clause, found in many contracts, specifies the
amount of damages that are to be paid to the victim, in case of breach of
contract. Courts are generally willing to enforce these, however, these clauses
are always scrutinized. They are scrutinized because courts refuse to enforce
‘penalty clauses’, which is what a liquidated damages clause becomes when it
specifies an amount higher than what the courts consider to be the expectation
damages for breach of that specific contract (the amount of money it would
supposedly take to put the victim of the breach in the same position as he
would have been had the contract been performed).
Let
us consider an example. Imagine that Justin Bieber signs a contract with a concert
venue, promising that he will perform at that venue at 1:00 PM on May 25.
Because the venue is planning to spend a lot of resources and effort to promote
and prepare for the concert, and because they do not want to tarnish their
reputation with a no-show, they want to make extra sure that Bieber will show
up. Thus, they specify that if Bieber does not show up by 1:00 PM on May 25 to
perform, he must forfeit $1 trillion to the owners of the concert venue, a figure
far higher than the total expenses that they will incur to promote and prepare
for the concert.
Feeling
confident that he will not break his engagement, Bieber signs the contract.
Unfortunately, in a fit of youthful exuberance, Bieber parties too hard on the
night of May 24, and does not show up for 1:00 PM at the concert venue the next
day. According to the contract, Bieber must forfeit $1 trillion to the owners
of the concert venue. Now, the question is: should the courts enforce this term
or not?
I
think that in this case, they should not. Why? Because it is impossible in this
case for Bieber to fulfill his contractual obligation through Specific
Performance, given the time-sensitive nature of the task Bieber promises to
perform. The default rule governing this case should be that the venue is
entitled to a modified form of Specific Performance, that is, Bieber doing the
concert at that venue on a different date, plus compensation for any costs that
the venue must incur to reschedule the performance, including the cost of
mollifying and refunding the tickets of disappointed patrons. If they do not
want this, than their other option should be to collect Expectation Damages,
calculated so as to be as generous as possible to the venue, from Bieber. The final option is, in the unlikely event
that paying the $1 trillion specified in the clause is less onerous to him than
these two options, than Bieber should be allowed to opt to pay the $1 trillion
instead.
In
what cases should penalty clauses be enforceable, if any? I think that they
should only be enforceable when there is a possibility still open to the promisor
of specifically performing. Though all contracts are to some extent
time-sensitive, many are less so than the Bieber example given above. I suggest
that for a penalty clause to be enforceable, the promisor must first breach by
missing the deadline set in the contract, and then he must be allowed a period
of time deemed reasonable by the court to correct his mistake and perform the contract.
This gives the breacher an option: perform the contract within the grace period
allowed by the court, or pay the sum of damages, ‘penalty’ or not, specified in
the contract.
With
this option, the breacher can determine which is more costly for him:
performing the contract in the grace period, or paying the agreed damages. The
more certain, ex ante, the contracting parties want to be that potential
breachers will choose to perform the contract in these circumstances, the
higher they can set their agreed damages clauses in the contract. Parties who
highly value certainty in the performance of their contract will choose to set
their agreed damages higher than parties who value certainty in the performance
of their contract less highly. Allowing parties to tailor their contracts based
on their preferences in this regard is positive, as it allows for the existence
of contracts that are more suitable for advancing the joint-interests of the
contracting parties.
But
how about for very time-sensitive contracts such as the Bieber hypothetical
discussed above? Shouldn’t the parties be allowed a way to make their
preferences for certainty of performance known and executable here too?
Ideally, yes, but it is simply too harsh to allow potentially astronomical
stipulated sums of damages to be awarded when the breacher has only one,
time-constrained shot at performance. The reasoning is related to the
recognized contract defense of Impossibility, where a fundamental change in
circumstances has virtually or literally made the performance of the contract
impossible for one of the parties. In such cases, courts will usually excuse
the party in breach from paying damages. Though it is not impossible for Bieber
to have shown up to the concert on time, once he has missed the concert, it is
then literally impossible for him to perform his end of the contract. While he
should by no means be excused from all damages for this, he should not have to
pay the potentially astronomical amounts that could be specified in ‘penalty
clauses’.
Thus,
the courts’ complete rejection of penalty clauses is not a good solution, but
neither is accepting all penalty clauses, in all circumstances. Instead,
penalty clauses should be enforceable, but only if the party in breach has a
realistic opportunity to mend his ways and perform the contract after all in
order to avoid the penalty. Otherwise, for very time-sensitive contracts such
as the Bieber hypothetical described above, the breacher should have the option
to undertake a modified form of Specific Performance (performance on a
different date), plus paying the victim back for necessary rescheduling costs, provided
that the victim wants this.
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