Fixing unfair contracts.

• Author: Ben-Shahar, Omri

INTRODUCTION I. THE PROBLEM OF UNFAIR TERMS A. Unfair Terms B. Three Solutions 1. The most reasonable term 2. The most unfavorable term 3. The minimally tolerable term II. MINIMALLY TOLERABLE TERMS: A CONCEPTUAL INTRODUCTION A. Minimally Tolerable Terms and the Freedom to Bargain B. Grounds for Intervention C. Cross-Doctrinal Foundations D. Identifying the Tolerable Threshold III. DOCTRINAL APPLICATIONS A. Severability Clauses B. The Doctrine of Partial Enforcement C. Unconscionability 1. Price and interest rates 2. Arbitration clauses D. Liquidated Damages E. Conditions in Insurance Contract IV. WHY ARE MINIMALLY TOLERABLE TERMS USED? A. Market Power and Bargained-For Advantage B. Unclear Boundaries C. Hidden Advantage and Bad Faith D. Duress and Contractual Hold-Up CONCLUSION INTRODUCTION

Imagine the following situation: As a student in a law school course, you are regularly assigned a daily reading load of 20 pages in preparation for the next day's class. Today, however, you received an extraordinary assignment of 200 pages, clearly more than you can feasibly prepare in one day. What should you do? What would be a principled mode of action, given that you cannot renegotiate or otherwise modify the command? Should you resort to the normal, "reasonable" practice of preparing 20 pages out of the assigned 200? Or should you, perhaps, disregard the unreasonable command of 200 altogether and in the absence of any other affirmative instruction read 0 pages? Or, perhaps yet, should you disregard only the unreasonable excess of the command and prepare the maximum level that is still tolerable, of say 50 pages?

This dilemma, I argue, is similar to one that is at the core of several basic doctrines of contract law. While this metaphorical dilemma is not set in a bargained-for exchange but instead in a hierarchical relationship, it captures the challenge created by one-sided, unfair commands. When a contract contains a term that is excessive or unfair, the law might consider it unenforceable, but it also has to set a substitute provision. Should the unfair term be replaced by the most reasonable majoritarian term (analogous to 20 pages in the above hypothetical)? Should the dictating party be "punished"--incentivized not to go too far--by replacing the unfair term with something least favorable to her (analogous to 0 pages)? Or, should the unfair term be reduced merely to the highest level that the law considers tolerable (analogous to 50 pages)?

This Article explores the problem of how to fix unfair terms and illustrates its solutions in existing law. It is an everyday problem that comes up in numerous settings, but, surprisingly, it has not received a systematic theoretical treatment. There is no single compelling approach to this problem and, indeed, as Part I shows, all three solutions--and only these three--can be traced across different contexts and legal traditions. Still, the analysis in this Article focuses primarily on the third regime--the one that intervenes to the least extent and fixes the unfair term only so much (or so little) as to make it minimally tolerable. This regime has received less notice in commentary than it deserves.

It might plausibly be conjectured, before reading this Article, that the minimally tolerable term criterion is esoteric, an academic curiosity at best. Surely, so goes the conjecture, if a court takes the trouble to correct an unfair term in the contract, it would "finish the job": it would naturally replace the offensive term with the most reasonable alternative, not with a barely tolerable one. Why let a party who overreached get away with the maximum allowable advantage? This Article demonstrates, perhaps surprisingly, that the minimally tolerable term criterion is quite prevalent. It shows how courts use it in a variety of legal contexts as a mainstream solution to the problem of unfair and unconscionable terms. One such doctrine is partial enforcement (or its archaic predecessor, the "Blue Pencil Rule"), and its application in the context of covenants not to compete. I show that when noncompete clauses are excessive, they are generally brought down to the maximum allowable level. Another doctrine studied here is unconscionability: what do courts do when a distributive term is struck as unconscionable? Quite often, it turns out, the vacated term is replaced with the minimally tolerable one, most favorable to the strong party. Yet another example involves the judicial supervision of liquidated damages. In some legal traditions, excessive liquidated damages are reduced to the maximum allowable level--the measure closest to the agreed sum, such that if it were the one agreed upon in the first place, the court would have enforced it.

Before it surveys the doctrinal prevalence of the minimally tolerable term criterion, this Article sets up the context in which the criterion operates, and provides a theoretical foundation for this regime. Part I identifies the minimally tolerable regime as one of three discrete and conceptually coherent solutions to the problem of how to fix unfair terms. Part II then analyzes the conceptual grounding of the minimally tolerable term criterion--the legal principles with which it is consistent and how it ties with other practices in various areas of the law. It shows that what underlies the minimally tolerable principle is a specific conception of severability (or divisibility) of contractual provisions, and that the principle of waiver can lead to a similar solution. Further, this Part demonstrates the prevalence of similar solutions in other areas of the law outside contracts.

Part III offers a brief cross-doctrinal survey and invites the reader to recognize that the minimally tolerable principle has broader application than one might expect. Recognizing the instances in which this regime applies and when it is rejected sets the stage for the normative inquiry in Part IV, which suggests several justifications for this practice. The normative defense is anything but straightforward. Admittedly, there is something objectionable about a legal rule that accords the strong party, who went too far in exploiting its bargaining power, the maximum allowable advantage. Why not reform the contract more aggressively? If courts already step in, why not take the opportunity to undo the effects of unfettered bargaining power? Legal solutions that favor the weak party, that level the playing field, are usually more appealing. Moreover, how do courts account for the bad incentives that minimally tolerable terms generate? Namely, the incentive to draft excessive terms, knowing that at most courts will only strike down the excrescence?

The key observation made here, in justifying the use of minimally tolerable terms, is that the problem of fixing unfair contracts is merely a species of gap filling. The court that vacated an unfair term has to decide how fill the newly created gap. If the court merely provides a gap filler, it cannot be too ambitious and it cannot undo the effect of uneven bargaining power (the source of which is unpacked in Part IV), or else its policy might backfire.

Indeed, the theme of this Article is part of a more general thesis concerning a principle of gap filling in contracts between parties that have unequal bargaining, or market, power. This thesis, which I develop elsewhere, (1) suggests that standard gap-filling approaches do not provide a workable prescription when the gap in the contract involves a purely distributive aspect that parties bargain over, such as price. The standard gap-filling criterion prescribes terms that are "majoritarian"--those that are used and sought by most parties. In law and economics, this criterion equates with surplus-maximizing gap fillers, because parties would naturally prefer provisions that accord them maximum joint gains, which they can then divide in any agreed-upon way by setting the price. (2) The problem with this surplus-maximization criterion is that it offers no recipe in the case in which the missing term is the price itself, or some other purely distributive clause. Missing prices cannot be filled with surplus-maximizing terms because more than one term maximizes the surplus. In fact, the choice of price is surplus-neutral.

To resolve this indeterminacy, a new principle of gap filling is needed, one of mimicking the bargain: the division of the surplus that would have been struck between these parties, given the allocation of market power. Here, courts cannot rely on average market prices because those do not mimic the bargain that would have been explicitly struck between these parties. This principle instead requires courts to fill gaps with terms that are sensitive to the division of bargaining power, and are more favorable to the party with the greater bargaining power. Any other method of filling gaps in distributive terms would be undone by the parties, at an increased transaction cost. If gap fillers do anything other than mimic the term this party could have dictated, they will have the ex ante effect of inducing this party to dictate the term in order to preempt any adverse allocation that would otherwise result from the gap filler. Perhaps even more than in other contexts, when the distribution is at stake it is likely that the stronger party will insist on contracting around a nonmimicking gap filler.

Thus, continues the argument, if courts have to fill a gap that arises from the elimination of an unfair term, the bargain-mimicking conception would dictate the term closest to the hypothetical bargain. More aggressive intervention would fail to achieve any redistributive results that might superficially or naively underlie it, and would be circumvented by the parties while imposing some deadweight loss.

In the end, though, this Article recognizes that any normative justification for the minimally tolerable term must account for the incentive problem and for the...