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

For more than five centuries, strict judicial scrutiny has been applied to contractual provisions which specify an agreed amount of damages upon breach of a base obligation. Although the standards determining the enforceability of liquidated damage clauses have developed novel and labyrinthine permutations, their motivating principle has remained essentially immutable. For an executory agreement fixing damages in case of breach to be enforceable, it must constitute a reasonable forecast of the provable injury resulting from breach; otherwise, the clause will be unenforceable as a penalty and the non-breaching party will be limited to conventional damage measures. The historical genesis of this principle sheds some light on its original rationale. Relief against penalties was one of the earliest exercises of equitable interference, having developed during the fifteenth century when the common law had no adequate machinery for trying cases of fraud. At a time when legal rules permitted double recovery through the sealed penalty bond, as well as other recovery grounded in fraud, a presumption by the early equity courts that liquidated damage provisions carried an unusual danger of oppression and extortion would have seemed well justified. In addition, the promisor faced information barriers greatly increasing the risk of overestimating his ability to perform. Consequently, the equity courts apparently refused enforcement when either actual or presumptive evidence of unfairness indicated that recovery would result in an unjust, extravagant or unconscionable quantum of damages in case of a breach. The common law courts soon usurped and subtly altered the developing penalty rule, invalidating the agreed remedy in any case where it specified a significantly larger amount than conventional damage recovery. Applying the principle of just compensation for the loss or injury actually sustained to liquidated damage provisions, courts have subsequently refused enforcement where the clause agreed upon is held to be in terrorem – a sum fixed as a deterrent to breach or as security for full performance by the promisor, not as a realistic assessment of the provable damage. Thus, attempts to secure performance through in terrorem clauses are currently declared unenforceable even where the evidence shows a voluntary, fairly bargained exchange