Jiujitsu Behavioral Economics: Incentivizing the Holy Grail of Efficient Breach through Liquidated Damages

Dear legal doctrine, Please untie me! Best, efficient breach.

It is undoubtedly a familiar scene from many 1L Contracts classrooms. The Professor introduces the concept of efficient breach; specifically the notion that contracts should be engineered, through the amount of damages awarded, to incentivize breach in the name of efficiency. The proposal provokes gasps of indignation from the class, who protest that breaking a contract ‘just feels wrong’. Ah, the professor will say, you must think we’re in a morality classroom, but we’re actually in law school. Through a variety of models, based on rational actors, the professor will demonstrate that damages which encourage efficient breach, generally expectation damages, will produce overall gains in societal wealth by encouraging contracting partners to breach their contracts when it will maximize overall wealth. (The larger question of whether wealth is a value worth pursuing through legal engineering will be carefully delineated as a separate question.) The professor may support his case with a quotation from the Restatement of Contracts, which empahsizes that breaking a contract is a morally neutral event. The professor may contrast expectation damages against the problematic concept of liquidated damages. Liquidated damages specify, in advance, the amount that a contracting partner must pay if they breach a contract. Liquidated damages clauses, especially those that seem punitive, are often not enforced by courts. A professor may demonstrate that liquidated damages clauses might deter efficient breach and therefore are economically unjustified. The students, standing in awe before the sacred models, are generally cowed into silence. They’ve learned an important lesson about attempting to apply their moral intuitions to economic analysis of legal doctrines. But is the professor actually right? In a fascinating article, entitled Do Liquidated Damages Encourage Efficient Breach? A Psychological Experiment, Professor Tess Wilkinson-Ryan convincingly argues that liquidated damages clauses may actually do more to encourage efficient breach than expectation damages. This effect will continue even if the liquidated damages clause is punitive in nature.  This somewhat counter-intuitive result, (at least from a neo-classical economics perspective) hinges on the idea of shared community norms. When penalties for violations of ‘interpersonal obligations’ are not specified, individuals will act in accordance with what they perceive to be the norms of the community that they participate in. However, when violations are clearly specified, especially if they are somewhat nominal in character, people will begin to operate in a  ‘more strategic and self-interested’ manner. Professor Wilkinson-Ryan uses the example of the Boston Fire Department. In 2001, the Boston Fire Department changed their sick leave policy to allow 15 sick days per year. Previously, the amount of allowed sick days had been unspecified. After the change, the overall number of sick days taken doubled. Despite economic efforts to scrub it out, most people think that contract contains a moral element of promise. Furthermore, contracts are often formed as part of ongoing relationships that include a social component. Therefore, people may be reluctant to commit a moral violation of the contract, even when it’s the economically correct decision for them to do so.

A liquidated damages clause, by specifying in advance a sum to be paid in case of breach, will make it seem more socially acceptable to breach. Professor Wilkinson-Ryan cites an experiment in Israel. A certain set of day cares began assessing a small fine if parents were late to pick up their children. A control group did not assess such a fine. After the day cares began to levy the fine, the rate of parental lateness increased significantly. By relying on a specific monetary penalty, rather than a cultural norm, the willingness of individuals to breach increased. There is an emerging field of scholarship that emphasizes people rely on moral heurestics to guide their actions. In this case, keeping one’s promise, which a layperson assumes a contract to be, is assigned a moral weight that may outweigh whatever economic gain they would gain by breaching, if expectation damages were to be awarded. Liquidated damages clauses, by monetizing morality, assuages whatever moral reservations a person may have about breaching their contract for a better opportunity. Most people seem to perceive a difference between a standard contractual promise and a contractual promise that contains an exception that acknowledges the possibility of breach.

In her first experiment, Professor Wilkinson-Ryan showed that subjects, on average, were willing to breach hypothetical contracts, containing liquidated damages clauses, at a lower price than those which did not contain such a clause. This effect held even though the later contracts included a statement that the ‘law of contracts’ would award to the breached against party a sum equivalent to the liquidated damages clause. In two more experiments, Professor Wilkinson-Ryan showed that this effect continued even if the liquidated damages clause awarded a higher sum than the law of contracts. (1,100 dollars v. 1,000 dollars) Professor Wilkinson-Ryan concludes that liquidated damages clauses have a debiasing effect; an individual will now view breach of a contract as an anticipated contingency rather than a morally problematic breaking of a promise. Perhaps a future student, using the insights of Professor Wilkinson-Ryan, will surprise a Contracts professor by demonstrating how legal doctrines, such as liquidated damages, can better produce economically beneficial results while actually reckoning with the moral sentiments and intuitions of individuals.