ContractsProf Blog

Editor: Jeremy Telman
Valparaiso University Law School

Monday, June 1, 2020

Teaching Assistants: The Myth of Optimal Expectation Damages

Theresa Arnold, Amanda Dixon, Madison Whalen, and GulatiMitu Gulati (right) (the Authors) have posted on SSRN their forthcoming article, The Myth of Optimal Expectation Damages, which is forthcoming in the Marquette Law Review.

The Authors first review various critiques that the law and economics approach has offered to the theory that expectation damages are optimal.  The critics identify reasons why expectation damages are sometimes over-compensatory and sometimes under-compensatory.  One would expect that sophisticated parties engaging in private ordering would choose the remedy best suited to their transaction, and it turns out they often do.  However, courts sometimes do not allow parties to determine the remedial theory most appropriate to their transaction; rather, courts set aside the parties' negotiated terms and substitute expectation damages in litigated cases.

A few scholars have pointed out, on a theoretical level that it is unlikely that expectation damages would be appropriate for all types of transactions.  The Authors show empirically that parties in fact choose bespoke remedial regimes rather than just accepting off-the-rack what the common law offers.  They have to limit their study to situations in which the general hostility to penalty clauses will not come into play.  Parties would not bother to negotiate for damages above expectations knowing that a court would strike such a provision as an impermissible penalty.  The pre-payment of bonds issued in the international debt market provided the Authors with an appropriate context in which to study choice of remedies.

Pre-payment hurts lenders, who were expecting payments throughout the term of the loan.  Parties negotiate for a pre-payment option, which courts treat as a contract term rather than as a permissible liquidated damages provision or as an impermissible penalty provision.  The Authors hand-coded a dataset of 1500 provisions and found the following:

  • Parties in different economic settings contract for different damage measures;

  • Many of these measures yield amounts significantly higher than the expectation damages measure; and

  • Almost no one contracts for anything resembling expectation damages.

They followed up on this data by interviewing participants in the transactions. They learned that the lenders regard these transactions as akin to joint ventures.  The pre-payment option gives the lenders the opportunity to share in the good fortune of a co-venturer whose financial stability has enabled it to pre-pay.  That seems fair, given that the lender will certainly share in a debtor's hardship should it be unable to pay.

One might think, as I initially did, that one might construe these pre-payment options as liquidated damages clauses.  The Authors address this possibility in their conclusion, noting that under the traditional analysis of such clauses, courts ought to strike these clauses as penalties, since they are designed to impose costs on breaching borrowers well in excess of expectation.  Courts are clearly accepting these clauses as independent contractual obligations rather testing to see whether they are impermissible penalties.

Although their findings are limited to a specific category of contracts, further empirical studies, such as the one the Authors have undertaken, could evidence the broader significance of the Authors' insights.  If they are correct that parties do not in fact prefer expectation damages, that fact ought to inform the way we talk about damages with our students.  These pre-payment option clauses might provide a model that our students can adapt to better serve their clients' interests in analogous situations.

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