Do liquidated damages encourage breach? A psychological experiment.

AuthorWilkinson-Ryan, Tess

This Article offers experimental evidence that parties are more willing to exploit efficient-breach opportunities when the contract in question includes a liquidated-damages clause. Economists claim that the theory of efficient breach allows us to predict when parties will choose to breach a contract if the legal remedy for breach is expectation damages. However, the economic assumption of rational wealth-maximizing actors fails to capture important, shared, nonmonetary values and incentives that shape behavior in predictable ways. When interpersonal obligations are informal or underspecified, people act in accordance with shared community norms, like the moral norm of keeping promises. However, when sanctions for uncooperative behavior are specified or otherwise formalized between the parties, behavior becomes more strategic and more self-interested. A liquidated-damages clause makes the remedy for breach explicit. Using a series of web-based questionnaires, I asked participants to indicate the lowest financial incentive that they would accept to breach a hypothetical contract, showing some subjects a contract with a liquidated-damages clause and others an otherwise identical scenario in which damages were determined by "the law of contracts." Subjects were more willing to breach a contract--an action normally dictated against by social and moral norms--when damages were stipulated. I argue that even when the law of contracts is clear itself on the legal remedy for breach, moral intuition differentiates between a background law like the rule of expectation damages and an obligation to pay damages included as a clause in the body of the contract. When parties stipulate damages, they clarify the respective expectations of the parties, permitting efficient breach without repudiation of the mutual understanding.

INTRODUCTION I. EFFICIENT BREACH AND LIQUIDATED DAMAGES A. Theoretical and Empirical Approaches to Efficient Breach B. Liquidated Damages in Contract Law C. Economic Analysis of Liquidated Damages D. Bounded Rationality and Liquidated Damages II. BEHAVIORAL ECONOMICS OF INCOMPLETE CONTRACTS A. Law and Theory of Incomplete Contracts B. Behavioral Economics of Incomplete Contracts C. Small Sanctions and Social Norms III. EXPERIMENTS: LIQUIDATED DAMAGES AND EFFICIENT BREACH A. Experiment 1: The Effect of Liquidated Damages on Willingness to Breach 1. Method 2. Results B. Experiment 2: Effect of Penalty Clause 1. Method 2. Results C. Experiment 3: Transparent Design with Follow- Up Questions 1. Method 2. Results IV. DISCUSSION A. Debiasing B. Reconciling Conflicting Incentives C. Implications for Contract Law CONCLUSION INTRODUCTION

Economists claim that the theory of efficient breach allows us to predict when parties will choose to breach a contract if the legal remedy for breach is expectation damages. (1) Relying on the assumption that individuals are rational wealth maximizers, law-and-economics scholars argue that promisors are indifferent as between performance and breach, (2) that promisees and promisors alike favor the rule of expectation damages, (3) and that penalty clauses will deter efficient breach by imposing extra costs on the promisor. (4) In other words, an economic prediction of human behavior says that when a promisor can make one extra dollar by breaching his contract, he will breach the contract.

As a descriptive model of human behavior, this set of premises and predictions lacks empirical support. Although the model of the rational actor is a useful tool in certain domains, it fails to capture important, shared, nonmonetary values and incentives that shape behavior in predictable ways. When interpersonal obligations--like contracts--are informal or under (5) specified, people act in accordance with shared community norms. However, when sanctions for uncooperative behavior are specified, codified, or otherwise formalized, behavior becomes more strategic and more self-interested. (6)

Consider the following anecdote: In December of 2001, the Boston Fire Department changed its sick-leave policy to allow 15 sick days per year. The previous system had allowed unlimited sick time, and the new rule was part of an initiative to bring professional management tools to the department. (7) In 2001, firefighters took a total of 6432 days. In 2002, the total number of sick days rose to 13,431--more than double the previous year. (8)

The new system was ostensibly more rigid, with a higher penalty for taking sick days--each sick day brought workers closer to the prospect of unpaid time off. The old system, by contrast, had no explicit penalty at all for sick time. The old system had something powerful in its favor, though: the firefighters had a tradition of "toughing it out" through illness, showing up for work even when it hurt. (9) The new policy made sick leave into a contractual entitlement rather than a breach of protocol.

The penalty for missing a day under the new system was not big enough to deter absenteeism on its own (15 days of illness per year is, after all, a lot--most people do not need to worry that they will need all of those days), but it changed the social norm in such a way that firefighters were willing to miss work in situations in which they otherwise would have felt obligated to show up. In the firefighters' case, the policy was costly, insofar as it encouraged workers to stay home even when they could have worked--the policy encouraged workers to breach in cases in which breach was overall more costly than performance. But what would happen if the incentives were more carefully calibrated, such that parties would breach only if it were efficient to do so? What if the Fire Department had been able to set the number of sick days at a level that would deter malingerers from exploiting the policy but encourage contagious workers to stay at home in cases in which they might otherwise have felt social pressure to show up for work? In that case, the formalization of the sick-leave policy might have done some good by reducing the effect of the social norm in cases in which it was arguably counterproductive. Put differently, formalizing the sanction for breach of an agreement might be a means of encouraging breach when it is otherwise efficient to do so.

This Article uses the analytical framework suggested by the firefighters' sick-time policy to map the relationship between liquidated-damages clauses in contracts and the parties' propensities to breach. The experiments reported here offer evidence for a positive relationship between the presence of a liquidated-damages clause in a contract and parties' willingness to breach a contract when breach is profitable. In other words, when the penalty for breach is formally included in the agreement between the parties--like the firefighters and the Fire Department--parties are more likely to choose to breach.

Liquidated damages are a means of making the sanction for breach explicit within a contract. Decision researchers have found experimental evidence that, when social norms are in conflict with efficiency incentives, a more explicit incentive structure leads to more self-interested behavior. (10) Even when the law of contracts is arguably clear itself on the legal remedy for breach, moral intuition differentiates between a background law like the rule of expectation damages and an obligation to pay damages included as a clause in the body of the contract. When parties stipulate damages, they clarify the respective expectations of the parties, permitting efficient breach without repudiation of the mutual understanding.

These experiments offer an account of the psychology of legal decision-making at the intersection of moral rules of promise and legal rules of contract. Considerable evidence suggests that most people think that there is a moral element to contract law and breach of contract. (11) In behavioral studies, participants routinely report that a contract is a promise, that breach of contract is immoral, and that breach is a moral harm even when the promisee is fully compensated for the expected benefit of the contract. (12) People think that the moral obligation is to perform as specified, not to confer a benefit as great as the value of the promised performance. (13) It seems that most people believe that the content of the promise is the text of the contract. In this Article, I will focus on cases in which the moral aversion to breach of contract is in tension with economic incentives--efficient-breach opportunities. In some cases, breach is more profitable than performance. However, under most common-sense moral theories of contract, performance is morally preferable and perhaps even obligatory.

A moral aversion to breach may prevent exploitation of apparently wealth-maximizing opportunities. However, I will offer evidence in these experiments that moral intuitions about contract are not immutable. Psychologists and behavioral economists have observed in many contexts that actors are more likely to defy a social norm when the penalty for their non-cooperation is real and explicit, but not so harsh as to deter the behavior on its own terms. (14) I argue here that weak sanctions in economics games serve the same function as liquidated-damages clauses in efficient breach situations. The liquidated-damages clause makes the remedy for breach explicit but not unduly punitive. Under these conditions, I predicted that people would be more willing to breach a contract, an action normally dictated against by social and moral norms. Data reported here suggests that people prefer to breach a contract with a liquidated-damages clause to one with an identical remedy provided by the rule of expectation damages. One interpretation of these results, supported by both descriptive and normative scholarship in this field, is that liquidated-damages clauses encourage efficient breach by changing the parties' understanding of the...

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