Behavioural Case for Contractual Penalties under the Common Law

Abstract

Abstract: One of the more important divergences between the common and civil laws relates to the enforceability of penalties in contracts. Put simply, the common law rejects penalties as being repugnant to the compensatory nature of contract damages. The civil law enforces penalty clauses as a manifestation of freedom of contract, unless the stipulated damages are determined to be manifestly excessive. This article compares these two approaches and finds the civil law rule to be the superior one. It uses insights from law and economics and, more importantly, from behavioural law and economics (BLAE) to show that penalties can be used to encourage parties to make more rational decisions. In summary, BLAE shows that penalties serve numerous functions other than punishing a party for non-performance. Penalties serve to signal the reliability of a party to provide additional resources to improve the chance of timely performance and to allocate the risk of loss to the most efficient insurer. It concludes that the common law's law of liquidated damages (penalties) should be rejected and the enforceability of penalties should only be limited by the doctrine of unconscionability.