Broadly speaking, the law of contract remedies is addressed to two questions: when may a disappointed promisee compel the actual performance of his agreement and, once it has been determined that he is entitled to money damages only, how is his compensation to be measured? The materials collected in the preceding sections of this chapter indicate the range and complexity of the rules that have been devised to answer these two questions. In this section we take up what is, in some sense, a more fundamental question regarding the status of the law of remedies as a whole: to what extent are the legal rules that define the consequences of contractual breach subject to modification or displacement by the contracting parties themselves? Put differently, to what extent are the parties free to treat these legal rules as mere suggestions and to substitute for them a regime more to their own liking (which courts of law will then be bound to respect)?

On the one hand, it may be said that since contract law is merely an instrument for effectuating the wishes and intentions of the parties, they should be given maximum freedom to say what constitutes a breach and to define its consequences. On the other hand, it can be argued that courts properly take an interest in the preservation of their own authority and have an independent duty to look after the interests of the contracting parties — a duty that will require the invalidation of even the most voluntary agreement if it is judged too one-sided or burdensome or is considered prejudicial to the interests of third parties.

The tension between these two ideas — felt in every branch of the law of contracts — becomes especially acute at three points in the area of remedies. The first concerns the validity of arbitration agreements. Often, a contract will provide that disputes between the parties are to be resolved by an arbitrator, that is, someone other than a judge sitting in a state-created court of law. To what extent are such agreements, and the awards made under them, subject to judicial review? Although the mistrust that judges have traditionally felt toward arbitration agreements has largely dissipated, contractual provisions of this sort continue to be scrutinized for their compliance with elementary standards of fair dealing and the requirements of public policy, and are far from being treated as self-validating fiats; to this extent, their effectiveness between the parties still depends upon judicial approval.

A second point at which the tension between contractual freedom and judicial prerogative becomes acute concerns the enforcement of what are sometimes referred to as "liquidated damage" clauses. In the absence of such a clause, the compensatory damages that A must pay for breaking his promise to B will be determined by a judge applying one or another of the formulae surveyed in Section 3. Suppose, however, that the parties themselves include a provision in their own agreement specifying the amount of damages to be paid in the event of breach. Will such a provision always be honored, regardless of the amount set by the parties or the circumstances under which it is to be paid? The answer to this question has been, and continues to be, in the negative — but a negative that is today more muted and ambiguous, and less restrictive, perhaps, of the parties' contractual powers, than it once was.

A third point of conflict between the principles of contractual autonomy and judicial supervision concerns the validity of disclaimers of liability — agreements that purport to eliminate the liability of one of the parties to a contract for certain harmful consequences of his own failure to perform. Strictly speaking, it is not the purpose of such a disclaimer to modify the parties' legal remedies (in the way that a liquidated damage clause does). Its aim is a more fundamental one: to eliminate a certain branch of liability altogether and thereby deny the predicate for applying any remedial rule at all. But although disclaimers and liquidated damage provisions are distinguishable, they are also, in a rather obvious sense, substitutes for one another, and it is useful to treat them together.

The following materials, it is hoped, will throw some light on the uneven progress that the idea of contractual freedom has made in the three areas just described — advancing along some fronts, losing ground on others, and gradually coalescing into a recognizable body of law that is at once both more and less free than its nineteenth-century predecessor.

A liquidated damages provision requiring the payment of an amount significantly larger than the harm actually suffered by the promisee may or may not be enforced, depending upon whether the amount specified in the provision represented (at the time of contracting) a reasonable prediction of the damages likely to result from the promisor's breach. It seems clear, however, that a provision will not be enforced if it deliberately sets liquidated damages at an amount greater than expected harm. A provision of this sort is a "penalty," and the distinction between penalties and legitimate liquidated damage provisions is the foundation on which this entire branch of contract doctrine rests. Recently, however, the soundness of the distinction has been questioned. Why shouldn't courts enforce penalty clauses, at least where they have been voluntarily agreed to by the parties? Consider the following argument:

[Penal clauses] have two important economic uses, and might be widely employed if they were permitted. First, . . . a penal clause may be useful to a buyer who has reason to believe that his normal money damages remedy will be inadequate and who wants to force his seller to buy his way out of the contract before breaching. Second, for a seller who has not yet developed a reputation for reliability, agreeing to a penal clause may be the cheapest way to persuade his buyers that he is willing and able to perform. . . .

The economic analysis of penal clauses makes clear that a clause of this sort cannot simply be condemned as nothing more than a side bet between the parties which serves no useful social purpose. A penal clause may often perform a role, either as a risk-allocating or an information-conveying device, which increases the economic value of an exchange. There is therefore no reason to think that every clause of this sort constitutes what earlier writers called an economically "sterile" agreement. And in any case, since many jurisdictions enforce wagering contracts but forbid the use of penal clauses, the nonenforcement of penal clauses cannot be explained by a generalized hostility to gambling. (Query: Is a wagering contract really economically sterile? How might it enhance the utility of the contracting parties?)

A second possible explanation for the hostility to penal clauses (although one which is rarely articulated) is that enforcement of such provisions would efface the fundamental distinction between punishment and compensation and give private parties the power to make breach of contract a crime. If private parties can create their own criminal law, one might argue, the power and authority of the state will be undermined.

This argument would have some force if, in addition to merely stipulating penalties for breach, the parties to a contract could also hire private protection agencies to enforce their bargains by any means necessary. Legal recognition of an arrangement of this sort would tend to weaken the state's monopoly on the means of violence and make it more difficult for the officers of the state to enforce even those agreements which fell within its jurisdiction. But legal recognition of penal clauses alone would not have this effect, so long as any private party wishing to enforce such a clause could do so only by invoking the power of the state through its judicial tribunals.

Furthermore, the economic utility of penal clauses makes it unreasonable to assume that almost all clauses of this sort are extracted under duress and that their flat prohibition is merely a convenient way of policing the bargaining process. Undoubtedly, some penal clauses ought to be invalidated because of duress, but an irrebuttable presumption is medicine which kills the patient. The important point is that even if courts were to continue to presume that every penal clause has been agreed to under duress, but to allow the introduction of evidence to rebut the presumption, it would be a doctrinal revolution.

A. Kronman & R. Posner, The Economics of Contract Law 260-261 (1978).

For a somewhat similar attack on the distinction between penalties and liquidated damages, see Goetz & Scott, Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach, 77 Colum. L. Rev. 554 (1977). How might the distinction be defended? It has been suggested that penalty provisions give the promisee an incentive to make a (socially wasteful) investment in efforts to induce the promisor's breach and should therefore not be enforced. See Clarkson, Miller & Muris, Liquidated Damages v. Penalties: Sense or Nonsense?, 1978 Wis. L. Rev. 351. But doesn't the same problem exist where a liquidated damages clause, originally intended as a good faith estimate of the promisee's expected loss, sets damages at an amount well in excess of the parties’ revised prediction of what the loss will be? Should a clause of this sort be enforced? Would it be enforced under the rule of McCarthy v. Tally? Under U.C.C. §2-718(1)?

As the passage quoted above suggests, a penal clause may be useful both to the promisee (since it gives him the power to compel the other party's performance if he wishes) and to the promisor (by providing him with the means to make his commitment more believable than it might otherwise be). Penal clauses are not, however, the only device the parties may employ to achieve these ends, and so long as such clauses remain unenforceable as a matter of law, alternative methods must be used. Consider the following case. A makes a long-term contract to supply B with parts B needs in his manufacturing process. B is worried that A may breach, after B (at great expense) has established a production line in reliance on A's contractual commitment. An enforceable penalty clause would increase B's confidence in A's promise. Alternatively, assuming that any clause of this kind would be unenforceable and therefore worthless B may insist that A set up his own manufacturing process in such a way that, unless A makes expensive changes in his plant, he will only. be able to produce parts for B's process. This is simply another way of raising the cost to A of breaking his promise, and A himself may benefit from such an arrangement since it gives him a way of increasing the credibility of his own promise. From the parties' point of view, the great advantage of an arrangement of this sort is that it is self-executing, that is to say, it is an arrangement whose effectiveness does not depend upon judicial approval (as a penalty clause does). For more on this fascinating subject, see Klein, Crawford & Alchian, Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, 21 J. Law & Econ. 297 (1978); Klein & Leffler, The Role of Market Forces in Assuring Contractual Performance, 89 J. Pol. Econ. 615 (1981); Williamson, Credible Commitments: Using Hostages to Support Exchange, 73 Am. Econ. Rev. 519 (1983); Kronman, Contract Law and the State of Nature, 1 J. Law Econ. & Org. 5 (1985).