Having the cake and eating it too: efficient penalty clauses in Common and Civil contract law

In this paper we examine one of the areas where there is a marked difference between Civil and Common contract law, that of the enforcement of liquidated damages and more particularly of penalty clauses. Common law judges are quite reluctant to enforce liquidated damages, especially if they believe that they include penalty clauses which are not enforceable. On the contrary, in almost all European contract laws liquidated damages are readily enforced, as are penalty clauses when they are not manifestly excessive. Although most law and economics scholars have criticized Common law courts for the non-enforcement of penalty clauses, there is a sizable minority of scholars who have defended the Common law "non-enforcement" policy on the ground that penalty clauses are inefficient because they hinder efficient breach. However, and despite the merits of the arguments advanced by advocates of the non-enforcement of penalty clauses, we believe that Common law's rejection of penalty clauses is inefficient. We further show that the Civil law solution to the problem is not only comparatively more efficient, but that it can also appease the worries of those scholars who are afraid that efficient breaches will be deterred. The solution that Civil law systems give to the problem manages to enforce the parties' wishes and to avoid deterring efficient breaches. However, we point out that in order for the Civil law systems to take advantage of this superiority, the interpretation of their Civil Codes should be guided by economic analysis and the respect to the wishes of the contracting parties. (C) 2003 Elsevier Science Inc. All rights reserved.