Primary Remedy for Breach Should be Damages

Economists claim that the theory of efficient breach allows us to predict when parties will choose to breach a contract if the legal remedy for breach is expectation damages. Relying on the assumption that individuals are rational wealth maximizes, law-and-economics scholars argue that promisors are indifferent as between performance and breach, that promisees and promisors alike favour the rule of expectation damages, and that penalty clauses will deter efficient breach by imposing extra costs on the promisor.

In other words, an economic prediction of human behaviour says that when a promisor can make one extra dollar by breaching his contract, he will breach the contract.

As a descriptive model of human behaviour, this set of premises and predictions lacks empirical support. Although the model of the rational actor is a useful tool in certain domains, it fails to capture important, shared, nonmonetary values and incentives that shape behaviour in predictable ways.

When interpersonal obligations like contracts are informal or underspecified, people act in accordance by means of shared community norms. However, when sanctions for uncooperative behaviour are specified, codified, or otherwise formalized, behaviour becomes more strategic and more self-interested. Consider the following anecdote: In December of 2001, the Boston Fire

Department changed its sick-leave policy to allow 15 sick days per year. The previous system had allowed unlimited sick time, and the new rule was part of an initiative to bring professional management tools to the department.

In 2001, fire fighters took a total of 6432 days. In 2002, the total number of sick days rose to 13,431—more than double the previous year. The new system was ostensibly more rigid, by means of a higher penalty for taking sick days each sick day brought workers closer to the prospect of unpaid time off. The old system, by contrast, had no explicit penalty at all for sick time. The old system had something powerful in its favour, though: the fire fighters had a tradition of “toughing it out” through illness, showing up for work even when it hurt. The new policy made sick leave into a contractual entitlement rather than a breach of protocol.

The penalty for missing a day under the new system was not big enough to deter absenteeism on its own (15 days of illness per year is, after all, a lot—most people do not need to worry that they will need all of those days), but it changed the social norm in such a way that fire fighters were willing to miss work in situations in which they otherwise would have felt obligated to show up. In the fire fighters’ case, the policy was costly, insofar as it encouraged workers to stay home even when they could have worked—the policy encouraged workers to breach in cases in which breach was overall more costly than performance. But what would happen if the incentives were more carefully calibrated, such that parties would breach only if it were efficient to do so? What if the Fire Department had been able to set the number of sick days at a level that would deter malingerers as of exploiting the policy but encourage contagious workers to stay at home in cases in which they might otherwise have felt social pressure to show up for work? In that case, the formalization of the sick-leave policy might have done some good by reducing the effect of the social norm in cases in which it was arguably counterproductive. Put differently, formalizing the sanction for breach of an agreement might be a means of encouraging breach when it is otherwise efficient to do so.

This Article uses the analytical framework suggested by the fire fighters’ sick-time policy to map the relationship between liquidated-damages clauses in contracts and the parties’ propensities to breach. The experiments reported here offer evidence for a positive relationship between the presence of a liquidated-damages clause in a contract and parties’ willingness to breach a contract when breach is profitable. In other words, when the penalty for breach is formally included in the agreement between the parties like the fire fighters and the Fire Department parties are more likely to choose to breach.

Liquidated damages are a means of making the sanction for breach explicit inside a contract. Decisions researchers have found experimental evidence that, when social norms are in conflict by means of efficiency incentives, a more explicit incentive structure leads to more self-interested behaviour. Even when the law of contracts is arguably clear itself on the legal remedy for breach, moral intuition differentiates between a background law like the rule of expectation damages and an obligation to pay damages included as a clause in the body of the contract. When parties stipulate damages, they clarify the respective expectations of the parties, permitting efficient breach devoid of repudiation of the mutual understanding.

I. Efficient Breach and Liquidated Damages

A. Theoretical and Empirical Approaches to Efficient Breach

Under an economic analysis, breach of contract is efficient if it leaves no one worse off and at least one party better off. Put differently, economic analyses of breach are mainly concerned by means of situations in which breach is Pareto superior, rather than just overall profit maximizing. In contrast by means of moral theories that hold that breach of contract is morally wrong insofar as it requires one party to break a promise, the economic view regards the contractual obligation as an obligation either to perform or to pay damages in an amount equal to the expected benefit of performance. The law of contracts takes no explicit position on efficient breach, but the remedies for breach of contract are more or less in line by means of the economic analysis of contracts. The “penalty” for breach is set at the expectation level, which in turn provides optimal incentives for efficient breach. A promisor who is required to pay expectation damages in the event of breach will not breach unless it is profitable to do so even after compensating the promisee, meaning that the promisor’s incentives internalize the costs to the promisee. The economic prediction is that, under these laws of contract, parties will breach a contract whenever breach is more profitable than performance. The experiments in this Article are designed to test that prediction empirically.

Expectation damages, as noted above, provide arguably optimal incentives for parties to perform when performance is valuable and to breach when it is not. In the empirical tests reported in this Article, participants evaluate stylized efficient-breach scenarios in which it is clear that breach is the better economic choice, but this experimental design is not intended to gloss over common problems by means of damages awards for breaches of contract.

For breach to be Pareto efficient the promisee have to receive full expectation damages—that is, she have to realize the full expected benefit of the contract. There are legitimate reasons to believe that in a typical efficient-breach scenario, a real-world promisee will not be adequately compensated. First, damages are limited to losses that are foreseeable and reasonably certain, and there are no damages for idiosyncratic emotional losses stemming as of non-performance. And, at least some cases will burden the promisee by means of significant transaction costs. The examples and cases used in this Article attempt to minimize these concerns and offer situations in which the promise expects to earn a certain monetary profit as of performance and will receive as damages an amount equal to the original expected profit. This means a sacrifice of a certain amount of realistic complexity to make the incentives as unambiguous as possible for subjects.

The experiments and arguments in this Article build on both the normative premises described above (namely, that sometimes breach is preferable to performance) but in addition on the empirical and philosophical observation that most people think it is immoral to break a promise, and that breaching a contract is a form of promise breaking. The traditional moral view of contracts considers breach of contract a moral violation. Moral theorists like Charles Fried have argued persuasively that a contract is a promise, and that breach of contract is immoral for the same reasons that it is morally wrong to break a promise. In many respects, this view is in accordance by means of the common-sense moral theories of promise and contract, in particular because it identifies breach as a moral harm irrespective of the availability of damages for the promisee. Legal scholars writing regarding the moral harm of breach of contract have recently begun to articulate the nature of that harm in terms of its effects on our interest in human sociability and, in turn, on the moral culture of promising. The general claim is that there is a real psychological harm as of breach of contract stemming as of the alienation those results as of a repudiation of solidarity. At least one doctrinal claim in the same vein holds that when there is a divergence between the law of contracts and moral norms of promising, there are real harms to the moral culture.

In fact, as of the point of view of common-sense moral norms, legal remedies for contract are insensitive to the moral context of breach. Contract law espouses the principle of just compensation, meaning that the purpose and measurement of damages are oriented toward compensating the promise rather than deterring or punishing the one who breached. There is no extra punishment for wilful breach: a promissory who decides not to perform is subject to the same damages whether his breach is opportunistic or reluctant.

Courts do not normally require parties to actually keep their promises that are; they do not normally award specific performance. These tenets of contract law do not always reflect moral intuition, and, in fact, they are not particularly good descriptors of actual legal behaviour. In the earliest studies of real contractual relations, Stewart Macaulay found that many businessmen relied so heavily on the moral norms against promise breaking that they preferred informal deals to written contracts. More recent research on the notion of a “psychological contract” has offered substantial evidence that parties are sensitive to perceived breaches of both formal and informal contracts, and that breach reduces interpersonal trust and cooperation. Experimental researchers have shown, using actual form contracts that laypeople believe that they are legally and morally bound to the word of the document that they signed, even if it contains clauses that are unenforceable. Legal scholars have in addition discerned that the moral rule against breaking promises has such purchase in our culture that it is not only a moral norm but a social norm, and one that comes by means of real social costs, including loss of reputation.

The studies reported in this Article are extensions of previous research that demonstrated specifically that laypeople believe that breach of contract is immoral. In earlier studies, subjects were presented by means of breach-of contracts cases and asked to assess the legal, economic, and moral Implication of breach. They reported overwhelmingly that breach was immoral, and found it even more immoral when the promissory would realize an economic gain as of his breach.35 Subjects indicated that breaching a contract is a moral harm in itself, separate as of the loss incurred by the promissory. Subjects set damages awards significantly higher than expectation.

In aggregate, behavioural results on contracts are fairly clear that people think that breach of contract is morally problematic. Assuming that people are willing to incur a cost to them to avoid a moral harm, these experimental data suggest that people will be reluctant to breach contracts.

One helpful framing for the systematic resistance to breach is that it represents a kind of moral heuristic. A heuristic is a rule of thumb, and a number of commentators have observed that people seem to use these shortcuts not only for thinking regarding questions of fact, but in addition for making moral judgments. Jonathan Baron first noticed this in the domain of punishment.

He found that people ignore arguably important information regarding the effects of a given punishment, and base their punishment decisions solely on their notion of moral desert. Cass Sunstein has taken up this line of argument and argued that there is a catalogue of moral judgments that rely in part on heuristic judgments. That is, people mistake useful shortcuts for moral rules, and apply those rules to situations in which they have to no longer apply. This Article offers evidence that subjects have a bias against breach of contract. Although keeping one’s word is a useful heuristic in most situations, it is not necessarily helpful to continue to apply such a rule to a situation in which neither party would actually prefer performance the kinds of cases in these studies.

Implicit in the discussion of an anti-breach “bias” is the presumption that there are at least some cases in which breach is a better choice than performance. This claim is not intended to imply a strong stance in favour of wealth maximization as the dominant normative principle. Instead, I am making the weaker claim that in at least some instances, one party may be able to realize a benefit of breach devoid of harming the other party, and that in such cases, breach is preferable to performance. However, because promising is such a strong moral and social norm, parties may be biased against breach even in these idealized cases.

Subsequent sections of this Article will review behavioural literature and offer new empirical findings to suggest that liquidated-damages clauses may offer a means of de-biasing subjects against breach. This de-biasing can, in turn, help reconcile the conflict between the moral incentives to keep a promise and the economic incentives of efficient breach.

B. Liquidated Damages in Contract Law

Parties to a contract may stipulate the amount of damages in the event of breach, subject to at least two, and sometimes more, constraints. The first is that the actual damages have to be difficult to prove. The second is that the damages have to be reasonable at the time of drafting the contract. Some courts have in addition, or alternately, required that the liquidated damages not be substantially different as of the actual loss, measured subsequent to the breach. A liquidated damages clause has to be formulated to compensate the non-breaching party, rather than to impose a penalty on the would-be breacher. Just as punitive damages are not permitted at the time of breach, a liquidated-damages clause is invalid if it has the intent or the function of punishing the breacher.

This rule is the subject of considerable academic debate, and some states are in fact more liberal in their approach to liquidated damages than others. Nonetheless, the broader principle that the liquidated damages have to represent an attempt to quantify losses in advance, rather than set a punishment for non-performance, remains settled law. Legal scholars have argued that there are justifications for the special scrutiny afforded to liquidated damages clauses apart as of the principle of compensation. Permissive readings of liquidated-damages clauses may systematically disadvantage less sophisticated, less informed, or otherwise less powerful parties.48 If one party has some private knowledge of a large probability of breach, or is more savvy regarding the background laws, she may be able to insert a penalty clause that the other party either ignores (thinking breach is unlikely) or mistakenly believes to be the legal rule. Others have argued, however, that fear of imbalance in bargaining power alone does not justify the rule. In theory, at least, a contract that purported to penalize one party unfairly would be problematic on grounds of unconscionability.

C. Economic Analysis of Liquidated Damages

An alternate justification for the scrutiny of liquidated damages is the economic argument that penalty clauses will deter efficient breaches. A penalty clause is essentially a liquidated-damages clause that requires over compensatory damages in the event of breach. Liquidated-damages clauses come under scrutiny because judges have to determine if they are in fact penalties rather than reasonable estimates of the promisee’s expected benefit. If the parties agree to a contract that will make them each better off by $1000, and one party is offered another opportunity that will give her a $3000 profit, surely the Pareto-optimal solution is to pay $1000 to the first party and make a total profit of $2000. However, if the first contract had specified damages at a level of, say, $2000, there would be no incentive to accept the second offer, an offer that would make some people better off and no one worse off. Although it is true that this would be an inefficient state of affairs, it is in addition true that contract law permits a number of inefficiencies, and usually leaves it to the parties to decide how to allocate the benefits and risks of a given bargain. The suspicion of liquidated damages is unusual in this respect.

In fact, the economic rationale for prohibiting penalty clauses has been disputed on its own terms. In his Lake River Corp. v. Carborundum Co. opinion, Judge Posner argued that penalty clauses may be economically justified as a means of facilitating efficient agreements by “making the promisor and his promise credible” but in addition by reflecting the parties’ own judgments upon weighing of the costs and benefits of the bargain. Charles Goetz and Robert Scott have in addition argued for the efficiency of penalty clauses.

Professors Goetz and Scott write that a penalty clause may represent the best effort of the parties to allocate risk, especially where a breach may result in non-compensable losses. In this model, the penalty clause serves as a kind of insurance, for which the promisor is the most efficient insurer. Penalty clauses are efficient insofar as they reduce transaction costs and make explicit the value of the bargain to each party, especially if that value may be difficult to prove. Furthermore, underlying the efficiency arguments is the notion that some penalty clauses are supported by an economic rationale because they may encourage parties to make beneficial contracts that they would not otherwise make. These arguments provide a good starting point for behavioural researchers, insofar as they ask how parties might use liquidated-damages clauses to clarify their intentions when they form agreements.

Alan Schwartz has argued that courts have to enforce liquidated-damages awards because parties have no rational motivation to contract for super-compensatory remedies.55 He observes that in a competitive market or when well-informed parties bargain, the promisee prefers expectation damages because the contract price is higher if the promisor risks paying a penalty.

As long as the penalty deters breach, the promisee will have paid extra for a fixed gain as of performance. Other authors have in addition noticed that when a competitive market exists, parties have no incentive to sign a socially inefficient contract (like a contract by means of a penalty clause). Economists have used theoretical models to show that stipulated damages are actually better able to correct for inefficiencies than court-imposed remedies.

D. Bounded Rationality and Liquidated Damages

Economic analyses of the effects of penalty clauses assume that parties are constrained by the background legal rules but otherwise will behave as rational wealth-maximizing agents. However, behavioural research suggests that moral or social norms may be more salient than legal rules, and, further, that wealth maximization will not be the only or even primary goal of the agents. I have reviewed evidence to suggest that the moral and social implications of breaching a contract may be severe enough that most people will, in a sense, penalize themselves by forgoing lucrative opportunities. In this section, I explore the possibility that liquidated damages and even penalty clauses might encourage parties to breach in cases in which they would otherwise follow the moral rather than the legal or economic rule.

The term “bounded rationality” refers to the notion that people, unlike perfect (and imaginary) rational agents, have limited cognitive resources, and therefore make some predictable reasoning errors that are not otherwise incorporated into economic models of behaviour. Melvin Aron Eisenberg uses principles of cognitive psychology to identify flaws in the law and economics justifications of penalty clauses. He argues that, given limited ability to imagine all of the possible manifestations of breach, and the concomitant optimistic belief by most parties that they will perform as specified, the incentive to deliberate carefully over a liquidated-damages clause is low. As such, a rule that assesses the damages as of the point of view of the parties’ best estimate of actual losses ex ante will serve only to exacerbate the problem. Rather, liquidated damages have to be compared by means of real losses after the breach has occurred, and that comparison have to determine the court’s decision unless there is a reason to think that the liquidated- damages clause was deliberately intended to encompass the circumstances of the breach in question.

I would like to briefly offer evidence as of other cognitive research that suggests the opposite conclusion—that in fact liquidated-damages clauses look even better in light of findings of bounded rationality. The benefit of stipulating damages is that drafting such a provision may force parties to deliberate regarding the expected benefit of the contract in a way that would otherwise be cursory or confused. I suggest three common cognitive limitations that reinforce this view, and I take these to be examples rather than an exhaustive list.

When parties specify the amount of damages in the event of breach as part of a contract, they may be forced to do some cost-benefit calculations that they would have otherwise neglected. Numeracy, or familiarity and comfort by means of manipulating and interpreting numeric information, is often vital for decision making. Specifying the gross benefit of the contract and then subtracting out the cost to the promisee is potentially an important process for helping to clarify the expected value of the contract to both parties.

And, in fact, some psychological research indicates that individuals who were otherwise making a decision devoid of the benefit of cost-benefit calculations can be prodded into more rational decisions just by asking them to perform the relevant arithmetic functions.62 Framed in terms of heuristic versus deliberative processing,63 liquidated damages may push the parties to deliberate regarding the expected value and possible risks entailed by the contract, rather than assessing the value by means of an affective snapshot.

These concerns are minimized, if not erased, for business-to-business con- tracts that involve accountants, lawyers, and institutional actors. But many contracts will involve at least one party (say, a homeowner in a contract for home renovation) who is not in the habit of thinking regarding the value of goods and services in terms of a cost-benefit calculation.

Second, weighing the costs and benefits of a choice potentially requires parties to assign numbers to goods that they do not normally think of in economic terms. That is, even if people are good at math (numeracy), they may neglect to assign numeric values to the goods implicated in a contract.

What is my profit on the enjoyment of a new kitchen or a piece of artwork? What is the cost of having workers in my house for a month or waiting another year for a delivery? Of course it is far as of impossible to calculate a value for these goods—but that does not mean that it is easy or intuitive.

Behavioural researchers have discussed the difficulty of turning an affective impression into a dollar value in the context of jury awards. Some values are not easily measured, especially when the promisee will benefit as of nonmonetary consequences of performance. There are many ways to figure this out: people can try to discern their willingness to pay for a service, they can compare prices as of other service providers, or they can try to assign a dollar value to the expected benefit. But these are not necessarily intuitive processes, and not everyone will be motivated to work out the expected value of a contract. Evaluating the value of a service like renovation has to not be particularly difficult a couple of alternate estimates could provide a helpful benchmark but could help parties clarify the value of the contract to themselves and one another.

A third cognitive benefit of a liquidated-damages clause is that it asks parties to think regarding fair compensation for breach at a time when they are not inclined toward punishment for the moral outrage of breaking a promise. In a previous paper, I found that subjects were inclined to set the penalty for breach at a lower amount when they were asked to draft a liquidated damages clause than when they were asked, ex post, to determine the appropriate level of damages for breach.66 I argued that the difference between negotiating for the penalty in the event of breach and deciding on a penalty after the fact has to do by means of the salience of the moral harm.67

Levying damages after the breach as a fait accompli makes the task more regarding assigning blame than allocating rights and duties. In the following section, I argue that there is another important psychological benefit to liquidated damages. A body of research as of experimental economics has shown that parties rely less on social norms to guide their decisions when sanctions for non cooperative behaviour are explicit, like Behavioural Economics of Incomplete Contracts.

Incomplete-contracts scholarship offers a useful framework for analyzing the role of liquidated damages. One way to think regarding the difference between contracts by means of and devoid of liquidated damages is as a difference in completeness. The literature on incomplete contracts provides useful insights for thinking regarding liquidated damages, inasmuch as a contract I arguably incomplete whenever it does not specify the contingencies and costs of breach. I first review economic and legal approaches to incompleteness.

Then, I suggest a number of relevant results as of empirical accounts of incomplete contracts. Experimental-economics games show that when contracts are not fully specified, parties rely on social norms to guide their behaviour. The role of social norms is diminished, though, when a monetary sanction for no cooperative behaviour is introduced.

A. Law and Theory of Incomplete Contracts

The doctrine of incomplete contracts allows for two possibilities when relevant terms or contingencies are not specified in the contract: either no enforceable contract exists, or the gaps can be filled using default rules of one kind or another.68 However, as many commentators have noticed, most contracts are incomplete, so the possibility of having no enforceable contract in all these cases is unrealistic.69 For the purposes of this discussion, I am interested in a form of incompleteness that will rarely render the contract unenforceable, namely, the absence of stipulated damages. In the case of this kind of incompleteness, the default rule is expectation damages (and maybe consequential damages if they are relevant). I will focus attention on the psychological relationship between the default rule, the explicit terms of the contract, and the background norms of contract and promise.

Legal scholars have argued that for reasons of flexibility, or cost effectiveness (lower transaction costs), or even strategy, parties may neglect to specify one or more terms under the assumption that the legal default rule will apply. In other words, incompleteness is often purposeful and efficient. The principle of expectation damages serves as a kind of default rule that parties can contract around (to a limited extent) by means of liquidated damages.

In their discussions of incomplete contracts, legal scholars have made assumptions regarding how parties understand and respond to default rules. Default rules are important, not only because of their substantive contributions to the terms of a contract, but because of the incentive effects that they have on parties drafting the contract. Some legal and economic scholars have argued that default rules have to try to mimic terms that the parties would have drafted or agreed to themselves. This argument assumes that when default rules are reasonably in accordance by means of the parties’ own preferences, the parties will prefer to leave gaps in the contract and rely on the defaults, as long as it is costly to negotiate and draft terms. A second school of thought on default rules takes the opposite tack and argues that at least some default rules have to be terms that parties will almost never want. Or, more specifically, that default rules have to be aimed at parties who would otherwise have incentives to leave a contract incomplete for strategic reasons for example, a party may be able to manipulate his share of the surplus by means of holding some information. The idea is that when parties are faced by means of disadvantageous but optional default rules, they will prefer to draft explicit provisions.

Central to these arguments is the idea that default rules matter because they affect whether parties draft explicit terms and how parties understand their rights and obligations under a contract. In some cases maybe many cases the default rules are irrelevant. When a contract is incomplete, parties have the ability to renegotiate the underspecified obligations at a later date. The opportunity to renegotiate the terms makes the default rule less important, under an economic analysis. Richard Creswell has expounded on this point using a particularly relevant example, the case of a high damage remedy. If it is in the promisor’s interest to breach, for example, the promisor have to be able to pay the promisee some amount greater than the value of performance to the promisee but less than his own cost of performance.

This idealized transactional structure minimizes the importance of default rules for incomplete contracts, but relies very heavily on assumptions of rational agency that may not bear out in the real world.

B. Behavioural Economics of Incomplete Contracts

Where a contract is incomplete, the economic assumption is that parties will either rely on the default rule or behave strategically and negotiate for optimal terms. There is another possibility, one that a number of behavioural researchers have begun to address: when parties omit terms as of the contract, they may assume that the relevant framework for their obligations is trust. That is, the parties trust that they are both bound by the same set of social norms, including promise keeping and reciprocity.

I have invoked the idea of norms frequently in this Article, and at this point it is worth taking the time to elaborate on the concept of norms, because the definition will shed some light on the role of sanctions. I will draw on Cristina Bicchieri’s rational reconstruction of social norms. The norm exists if the subject knows that the norm applies to certain situations, and the subject prefers to conform to the norm, on the following conditions: first, the subject have to believe that it is empirically true that people generally conform to this norm; and second, that the subject believes that other people exp