ABSTRACT
The paper proposes a different interpretation of the rules in force for penalty clauses both in Civil Law and U.S. Common Law. The tool used for this purpose is the huge mass of results that have been accumulated from cognitive psychology studies, pursuing the traditional goal of Law and Economics to identify an efficient system. The cognitive psychology tool is used to criticise the rigid scrutiny and sometimes voidness that the penalty clause is subjected to. The paper criticises the excessive generality of the system and proposes instead a greater distinction among cases, based on an understanding of cognitive psychology, in order to identify cases in which the complete enforceability of the penalty clause can be recognized.
The departure point for this work is the elaborate arguments of the American courts used to justify the voidness of the penalty clause in US Common Law: “the illusion of hope” based on which the parties, when subjected to a penalty clause, presumably overestimate the risks they face, do not realise the possibility of rather unlikely but harmful events, and erroneously trust in their ability to manage situations, making a protective attitude, a legal paternalism, necessary. This elaborate justification by the courts is translated in this paper into the language of cognitive psychology: the parties suffer from biases defined as overoptimism, overconfidence and illusion of control.
However, the paper seeks to avoid making extreme generalisations by hypothesizing the constant presence of these biases. The results of the experiments done by psychologists demonstrate that the consequences and the very presence of these biases change as the situations and characteristics of the subjects in question change.
In this sense, the paper seeks to adopt a new approach with respect to the approach characteristic of works inspired by the rational choice theory. The aim is not to formulate hypotheses valid in every case, but to examine individual cases: no attempt is made to contrast the always overoptimistic or overconfident man with the always rational man. By proceeding in this way, the paper sets for itself the goal of criticising paternalistic limits on contractual freedom by making use of a theory, cognitive psychology that typically demonstrates the systematic deviations in human choices from the rational model.
One distinction that might be introduced and that is examined in the paper is the distinction between sophisticated parties and naive parties. This is a very intuitive distinction: in fact, the party who makes wrong decisions bears the usual costs of his decisions and should have an incentive to learn. This distinction is followed by some scholars. Unfortunately, the empirical results of cognitive psychology do not confirm this hypothesis. The individual is far more reluctant to correct his own overoptimism and overconfidence on the basis of experience than might be imagined. It is reasonable to assert that, in the case of overoptimism and overconfidence, there is a general propensity not to learn from experience. Only when the feedback has certain unique characteristics, characteristics that at times can be had only in the laboratory, does the individual correct his choices or expectations on the basis of experience. This might make us think that the overall regime of the various legal systems is correct: if experience does not limit biases, there is no reason to treat some differently.
However, this paper did not stop at this conclusion but seeks to verify whether there are other processes or mechanisms that have a debiasing effect.
The attempt was made with regard to firms as hierarchic organisations. The aim was to see whether in a hierarchical organisation like a firm there might be decision-making processes that also have the effect of eliminating or mitigating the distorting effect of biases. The intention was not to affirm that debiasing mechanisms cannot exist for consumers as well, as an alternative to experience which, as has been stated, does not give outstanding results.
Attention was focused on entrepreneurial organisations understood as hierarchical structures because many processes by which decisions are made in business organisations seem capable of having a debiasing effect.
The results of the study were positive, in the sense that mechanisms were identified within hierarchical organisations which appear to have a debiasing effect on the choices made by the subjects. In hierarchical organizations, individuals are responsible towards others: subordinates towards superiors. In corporation, the administrators answer to a board of directors, which normally includes non-executive directors and sometimes independent directors. This responsibility of choice creates a pressure of accountability that is identified by psychologists as the source of greater risk aversion on the part of individuals. It is worth underscoring that this greater risk aversion will impact the choices made in accepting penalty clauses, and in this way should curb the illusion of hope that leads to non-optimum choices. But what may be more important is that the pressure of accountability has a debiasing effect. First, the subordinate cannot follow his intuitive judgment because then he could not give a satisfactory explanation to his superior. The superior normally demands an explanation that requires an investigation of the issue in all its aspects. In addition, the pressure of accountability encourages a more objective evaluation of projects, in the sense of an assessment based on comparison with the percentage of success achieved in similar cases (the “outside view of the problem”). Indeed, the superior may not be familiar with all the characteristics of the project and prefer a statistical evaluation. A choice based on statistical calculation is less vitiated by biases.
As can easily be guessed, the same reasoning is not valid for the individual businessman who owns a small firm. In this case, there is no pressure of accountability, since decisions are made directly by the owner himself. The “inside view of the problem,” i.e., the view not founded on a probability calculation based on similar projects, and with it the overoptimistic view, is destined to prevail. The debiasing mechanisms that have been identified with regard to hierarchical business organisations seem less identifiable in small companies run by a single entrepreneur.
All the more reason that our work did not identify debiasing mechanisms in the choices of consumers. We have seen that experience does not normally have an effect in this area. However, this does not mean that studies in the area of cognitive psychology are over and that we should think that the only solution is a rigid scrutiny of liquidated damages provisions, or even the voidness of penalty clauses. It is possible that cognitive psychology research identifies debiasing processes even with regard to consumer choices, for which reason legal paternalism would in some cases be unjustified.
The paper has a prescriptive conclusion. The concluding proposal is twofold. The first part involves Italian law. The Italian Civil Code of 1942 states at section 1382 that “the penalty may be reduced if (…) its amount is manifestly too high.” The courts and scholars have always held that the adverb “manifestly” must refer exclusively to the amount of the predetermined damages. The proposal asserts that manifest excess must be evaluated by taking into account not only the amount of the predetermined damage but also the process by which the consent of the parties was formed (for which, to pose some hypotheses, a penalty that is not very high compared to the damages that actually occurred but that is borne by a contracting party whose will was vitiated by the typical biases of overoptimism and overconfidence might be declared manifestly excessive; on the other hand, a penalty that is very high compared to the damage that actually occurred might be considered valid if the contracting party’s will, bound by the penalty clause, was formed through a process that guaranteed adequate debiasing mechanisms).
The second part of the proposal involves the penalty clause system in US Common law. The idea is to draw the penalty clause system into the rules of the unconscionability doctrine, while maintaining certain unique features. The unreasonableness of the damage would constitute substantive unconscionability. The second requirement (“Actual damages are not difficult to estimate”), which also causes the voidness of the clause, could be discarded. Rather, procedural unconscionabiliy should be required and should be identified by making use also of cognitive psychology to verify whether the choice is biased or not.