Unenforceable Contracts: Penalty Clauses and Specific Performance

Abstract

THAT many aspects of the common law may be explained in terms of economic efficiency, defined as wealth maximization, is a proposition that has been well-established by the work of Posner' and others. I have, along with others, provided arguments which partially explain why this is true.2 Thus, it is puzzling when there is some legal rule which cannot be so explained. To date, one of the main anomalies in the economic explanation of common law is the rule against penalty clauses in contracts. If two parties sign a contract specifying a payment in the case of breach and if the courts determine that damages are greater than the actual costs of the breach, the damages will not be allowed. Though there are some economic explanations for this behavior in the literature,3 these explanations have not been fully convincing.4 Another area in which economic analysis has not been fully satisfying is the area of specific performance. Kronman is able to explain some of the reluctance of the courts to order specific performance in the case of contracts, but he is still left with some puzzles.5 In this paper, I provide an explanation for both of these aspects of the courts' refusal to enforce contracts. The argument is based on Telser's