2013] PENALTY CLAUSES AS REMEDIES 687
been subject to substantial criticism by both courts
35
and commenta-
tors.
36
However, its continued application by the courts—in spite of
such criticism—also proves its continuing vitality as domestic United
States law.
37
The most common modern justification for the rule is
based on the theory of “efficient breach.” In effect, society as a
whole may be better served by a breach. If so, as long as the ag-
grieved party receives monetary damages compensating for its expec-
tation loss, breach will be more efficient than performance.
38
Critics argue that the “efficient breach” theory is flawed, both
as a matter of business reality and economic theory. Contrary to the
traditional theory of “efficient breach,” a penalty clause deterring
breach may actually be more efficient, because this will simply lead
the parties to negotiate and share the economic fruits of the contem-
plated breach.
39
However, this ignores the very real challenges in-
herent in negotiating in the context of what is essentially a bilateral
monopoly,
40
as well as the potential economic interests of third par-
ties in an efficient breach.
Critics of the common law approach also often argue in favor
of the “utility” of penalty clauses by pointing to various forms of
damages that are difficult to calculate or prove.
41
However, these ar-
guments fail to recognize that a true “liquidated damages” provision
addresses the same issue and is fully enforceable, as such. One of the
primary purposes of a “liquidated damages” clause is to provide for
damages that are difficult to calculate or prove. In contrast, a true
“penalty” clause is intended to deter a breach, rather than remedy
such a breach.
The above analysis is exemplary only and is not intended to
be exhaustive or to suggest that the common law approach is neces-
35
XCO Int’l, Inc., 369 F.3d at 1001-02; Lake River Corp. v. Carborundum Co., 769 F.2d
1284, 1288-89 (7th Cir. 1985).
36
See Goetz & Scott, supra note 29; Kenneth W. Clarkson, et al., Liquidated Damages v.
Penalties: Sense or Nonsense, 1978 WIS. L. REV. 351 (1978).
37
See, e.g., XCO Int’l, Inc., 369 F.3d at 1002-03; Lake River Corp., 769 F.2d at 1289
(noting the departures from this standard approach in certain areas, such as insurance law);
Hachem, Agreed Sums, supra note 16, at 147 (explaining that these departures are sui gene-
ris and typically involve what is, essentially, a tort, such as bad faith breach of an insurance
contract).
38
XCO Int’l, Inc., 369 F.3d at 1001; see POSNER, supra note 28 (for a more thorough
analysis of the theory of an “efficient breach”).
39
See Goetz & Scott, supra note 29, at 567-68.
40
POSNER, supra note 28, at 78.
41
Id. at 160.
7
Graves: Penalty Clauses as Remedies
Published by Digital Commons @ Touro Law Center, 2013