Recalibrating the governance of remedial clauses in contract law
In my contribution to the autumn 2020 issue of the Northern Ireland Legal Quarterly – titled ‘Recalibrating the governance of remedial clauses in contract law’, I make a case for a reformation of the rules governing the enforcement of remedial clauses. The pith of my contribution is that prevailing rules of contract law pay inordinate attention towards effecting interpersonal justice between contracting parties while losing sight of the adverse distributive implications and other social costs that may result. The rule against penalties is a common law precept that tempers contractual interpersonal justice so as to avoid unfair distributive consequences (or overcompensation) resulting from the enforcement of contracts; and apex courts in major commonwealth jurisdictions (eg Australia, New Zealand Singapore and the UK) have in recent times defended the place of the precept against attacks from critics. Yet, the prevailing conceptions of the rule against penalties across Commonwealth jurisdictions are not formulated in ways that particularly address the risk of overcompensation. Australia appears to be the only jurisdiction that has of late made an improvement, albeit slight, to its conception of the precept. This is because it considers that the event of breach is not a prerequisite for the application of the rule against penalties.
The postulations proffered in this contribution towards the reformation of the rules against penalties are as follows:
1) that the standard monetary remedies afforded by contract law to promisees (ie damages and restitutionary awards) should always be the default remedy except when legitimate reasons can be shown warranting the award of supercompensation through the enforcement of remedial clauses;
2) that, even if a promisee demonstrates a legitimate interest that would otherwise entitle them to a super-compensatory award, the courts should have the power to scale down any such award;
3) that the time for assessing the promisee’s legitimate interest to a super-compensatory award should be at the time of breach or when enforcement is sought, instead of the time of contracting;
4) promisees entitled to remedial clauses should take reasonable care to mitigate their exposure to loss(es);
5) that all remedial clauses should be governed in like manner, and the labels attached to apparently different types of remedial clauses (eg liquidated damages, forfeiture clauses, termination clauses and acceleration payment clauses etc) should be ignored and discarded;
6) that breach should not be a condition for the application of the rule against penalties.
These postulations hinge on the following submissions concerning what the purpose of contract law should be understood to be. It is submitted that the nature of contracting is as follows:
- the social and economic objectives of contract law are to enhance the empowerment or well-being of members of society through exchanges; and
- that contracting, just as life, ‘is the continuous adjustment of internal relations to external relations’.
The arguments made towards the above postulations may be summarised as follows. Contracts serve to enable members of society to maximise joint values through transactions, thereby increasing their private gain/satisfaction which may otherwise not be actualised. The body of monetary remedies (ie compensatory and restitutionary ones) recognised in modern contract law is generally sufficient to redress the effects of contractual disappointments that result from a promisor’s default. The precept of ‘net loss’ serves well in this regard to make up for the actual loss suffered by a promisee. Equally, the restitutionary damages in contract law also serve to confiscate the measure of value unlawfully derived by a defaulting promisor. In part, this appears to explain why contract law, while respectful of the notion of freedom of contract, has always been cautious in permitting the freedom to contract on remedial terms.
Yet, this body of monetary remedies has limitations in situations where the measure of loss to be suffered by the promisee or the measure of unlawful gain to be reclaimed from a promisor would be difficult to quantify. In such situations, contractually determined remedies may be permissible.
But then, the question arises as to the degree to which we may depart from focusing on the promisee’s actual injury and shift focus to his or her legitimate interest. That switch must be done conservatively, particularly by paying attention to the commercial specificities that shape the promisee’s business interests as they concern the contractual agreement in issue. For example, a bank or financial institution may easily satisfy entitlement to the enforcement of a super-compensatory remedial clause on account of the need to preserve its business model, even though a customer’s breach causes no actual loss. However, this does not justify treating promisees with apparent legitimate interests deserving of protection at the time of contracting as entitled to the literal enforcement of remedial clauses. The needs of the situation must be determinative. A given occasion may warrant ‘scaling down’ the enforcement of a clause in response to the size of the risk that actualised owing to contractual disappointment. This submission hinges on the reasoning that contractually agreed remedies serve as a form of contractual insurance that must be calibrated in a manner that corresponds to the injury suffered or the risk that actualises. The evisceration of the scaling-down component in the exercise of judicial control over remedial clauses is one of the factors responsible for the muddling of the rules against penalties, particularly causing its equitable origins to be de-emphasised, as it concerns liquidated damages. The fact that contracts are relational or dynamic arrangements highlights the imperative for reviving the scaling-down component of the rules against penalties.
People enter contracts with a sense of optimism concerning their performance intention, capabilities, or possibilities and may thus pledge to liquidated damages payments without fully considering future implications. Unforeseen adversities are soon likely to betray their feelings of optimism. But that is not the real issue; the real problem is that the injury that the promisee may suffer owing to contractual disappointment may be significantly less than the sum that the promisor pledged in his or her state of optimism. With this reality in mind, there should be legal recognition of contracts as dynamic arrangements. Enforcement should adjust to the needs of parties as their contract evolves, but with a view to ensuring that the promisee is not made worse off. With hindsight, we are equipped with information regarding the true measure of loss to which the promisee is exposed.
Additionally, with hindsight, we are also able to know what losses the promisee could have taken steps to avoid (ie mitigation) – eg by sharing more information with the promisor or by renegotiating with the promisor. In short, the argument is that legitimate interest should be assessed at the time of breach or the time of enforcement of the clause. That is because what may appear to be a legitimate interest at the time of contracting may turn out to be false at the time of breach or enforcement. Assessing ‘legitimate interest’ at the time of breach or at the time of implementation helps to disincentivise a promisee from holding out in situations warranting renegotiation.