Document Type

Article

Publication Date

2004

Center/Program

Center for Contract and Economic Organization

Center/Program

Program in the Law and Economics of Capital Markets

Abstract

Although compensation is the governing principle in contract law reme- dies, it has tenuous historical, economic, and empirical support. A prom- isor's right to breach and pay damages is only a subset of a larger family of termination rights that do not purport to compensate the promisee for losses suffered when the promisor walks away from the contemplated exchange. These termination rights can be characterized as embedded options that serve important risk management functions. We show that sellers often sell insur- ance to their buyers in the form of these embedded call options, and that termination fees, including damages, are in essence option prices. Further- more, we explain why compensation is of little relevance to the option price agreed to by the parties, which is a function of the option's value to the buyer, its cost to the seller, and the market in which they transact. We propose, therefore, a novel justification for why penalty liquidated damages may be higher than the seller's costs: They are option prices that reflect the value of the options to the buyer. The regulation of liquidated damages is thus tanta- mount to price regulation-a function outside the realm of contract law. Moreover, in light of the heterogeneity among optimal option prices, this Arti- cle also makes the case against the expectation damages default rule. In thick markets, we argue for enforcing the parties' risk allocation with market damages. In thin markets, we propose the default rule should encourage parties to agree explicitly to termination rights, including breach damages, by the threat of specific performance of their contemplated exchange or, in the case of consumers, by a default rule that provides them a termination option at no cost.

Included in

Contracts Commons

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