Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach

Abstract

Part I of this Article examines the role of liquidated damage provisions and penalties in the context of a general theory of efficient breach of contract. The proof problems inherent in fully recovering idiosyncratic values within the context of operationally practical damage sanctions may prevent the non-breaching party from recovering his subjective expectations if recovery is limited to legally determined remedies. The expected cost of establishing true losses under conventional damage measures will thus induce parties who face uncertain or nonprovable anticipated losses to negotiate stipulated damage agreements. The current penalty rule subjects these agreements to costly review, based not on the fairness of the process, but on whether the initial estimate sufficiently mirrors the anticipated provable loss. Part II examines the hypothesis that, absent evidence of process unfairness in bargaining, efficiency will be enhanced by the enforcement of an agreed allocation of risks embodied in a liquidated damage clause. We argue that agreed damage measures and in terrorem provisions represent, under many circumstances, the most efficient means by which parties can insure against the otherwise non-compensable consequences of breach. Our hypothesis is then also tested against a series of conditions in order to identify alternative legal principles that may provide less costly means of avoiding the harmful effects whose perception apparently prompted the current penalty rule