The Two-Contract Approach to Liquidated Damages: A New Framework for Exploring the Penalty Clause Debate

Over the years, a vast amount of academic literature has addressed issues surrounding liquidated damages clauses. Some scholars have written about the tests that courts apply to determine the enforceability of these clauses; many other scholars have debated the efficiency of enforcing “penalty” liquidated damages clauses. Surprisingly, however, there has been scant — if any — scholarly discussion about why courts ever enforce liquidated damages clauses at all.The importance of having a coherent theory of liquidated damages is twofold: First, if there is no such coherent theory, then it seems as though courts should not continue to enforce compensatory liquidated damages clauses. Second, in order to articulate a defense of or attack on “penalty” clauses, we must first be able to articulate what it is we are doing when we enforce compensatory liquidated damages clauses. This Article will bring the reader a fresh perspective on liquidated damages and will examine the unsteady theoretical foundations upon which they stand — an unsteadiness which appears to have gone unnoticed in the literature. This Article will argue that the lack of a justification for the enforcement of liquidated damages clauses is a glaring omission in the body of contract law and contract law scholarship, and, in response to this omission, this Article will provide a foundational theory upon which further debates can stand.The common understanding of liquidated damages provisions — pervading discourse on the topic — is that they are simply one of many clauses in a contract. In arguing for our freedom to contract about remedial terms, Richard Epstein writes: “Damage rules are no different from any other terms of a contract. They should be understood solely as default provisions subject to variation by contract.” While perhaps remedial provisions are written with respect to a particular eventuality, Epstein sees these clauses as components of the contract.Liquidated damages provisions are unique, though, to the extent that they are the only contract terms that refer to the eventuality in which the contract itself is breached. But, if as Epstein says, these provisions are no different from other terms of the contract, what is to stop a party who has breached some provisions of a contract from also breaching the liquidated damages provision? If a party breaches a contract and is then confronted with a liquidated damages clause that would require a payment much greater than that which would be required by (perhaps) expectation damages, why would the party not simply breach the liquidated damages provision as well? This presents a conundrum.On the one hand, if we want liquidated damages clauses to have any teeth, we cannot allow parties to breach them: If the clause is breached, we are back to square one, with a court determining the appropriate remedy for the breached contract. Furthermore, there would almost always be one party who, ex post, would consider the liquidated damages clause to be less attractive than submitting the remedial issue to the court. On the other hand, it is unclear if courts could offer a coherent justification for allowing parties to breach some terms of a contract but not others. In short, the questions raised in this Article are: (1) What does it mean for courts to “enforce” liquidated damages clauses? and, similarly, (2) What are courts doing when they “enforce” liquidated damages clauses?