THE EFFICIENT BREACH HYPOTHESIS: ITS IMPACT AND EFFECT ON THE PENALTY CLAUSE AS DEFINED UNDER COLOMBIAN LAW

by Juan P. Moreno September 20 2009, 13:36

I.          INTRODUCTION 

Inspired by the close interaction of law and economics, common law scholars have applied an economic perspective to bear legal problems in the last decades. This scholastic effort has produced interesting results in the United States where the sophistication of the courts and its judges allow a pragmatic application of economic theories to actual controversies. Economists analyze legal rules in terms of efficiency. [1] Reallocating resources in a society is considered efficient only if that reallocation makes someone better without making some others worse off. [2]

Economic theory has been broadly applied in the United States, particularly in the area of contract law. At the heart of its application lies the efficient breach hypothesis, a milestone of contract law and the law and economics movement. [3] Simply put, the hypothesis suggests that promisors should be permitted, if not encouraged, to breach a contract whenever the net gains resulting from said breach exceed the net gains of performance. [4]  Parties are therefore encouraged to complete the projects they consider efficient while abandoning any other contractual project that results inefficient or wasteful.[5]

In the United States the efficient breach hypothesis has been repeatedly endorsed by notable legal personalities like Richard Posner who has openly welcomed the hypothesis both as a scholar and as a judge. In Patton v. Mid-Continent Systems Inc, for example, judge Posner stated that:

 

                “[N]ot all breaches are blameworthy. The promisor may simply have discovered that his performance is worth more to someone else. If so, efficiency is promoted by allowing him to break his promise, provided he makes good the promisee's actual losses. If he is forced to pay more than that, an efficient breach may be deterred, and the law does not want to bring about such a result.”[6]              

The close interatction between economics and law and the innovations that arise from this dualism is not present in civil law jurisdictions where, unfortunately, the literature in economic law is scare. In Latin America and particularly Colombia, scholars and courts tend to focus on the status quo of the rule of law and limit their interpretation and analysis to a set of guidelines established in a code or a long-standing ruling. Innovative approaches to law tend to be minimalistic and rigid. As such, while the rule of law in common law jurisdictions tends to be dynamic and regularly adjusted through its case law; its civil counterpart tends to be static and immutable. This difference however does not, by any means, indicate that civil law is inferior from common law, it is just different.[7]  Nonetheless, lawmakers and adjudicators must be conscious of this difference before transplanting innovative legal theories to well-entrenched civil law systems.

This paper explores the possibilities of transplanting the efficient breach hypothesis into Colombian law. The paper centers its analysis in the effect the efficient breach hypothesis would have on the penalty clause.

Part II introduces a general overview of penalty clauses under Colombian law and highlights its multifaceted use in contract formation and enforceability.

Part III stresses the role of penalty clauses as means of avoiding litigation and concludes that efficiency is best achieved by these clauses.

Part IV presents a general conclusion.

II.   HARMONIZING THE EFFICIENT BREACH HYPOTHESISWITH THE PENALTY CLAUSE 

           

An issue that arises from applying the efficient breach hypothesis to Colombian contractual law is the effect the hypothesis has in penalty clauses. American courts generally refuse to enforce liquidated damages (i.e. anticipated damages agreed by the parties) if the liquidated damages substantially exceed the actual damages caused to the non-breaching party i.e. if such damages are grossly disproportionate.[8] If the court finds the liquidated damages to be excessive, i.e. a penalty, the clause is usually, if not always, deemed unenforceable.[9] In other words, under common law penalty clauses are declared unenforceable because they hinder efficient breaches.[10]

The efficient breach hypothesis limits the enforceability of liquidated damages to very limited situations and upon the fulfillment of two conditions. First, the stipulated amount must be a reasonable estimate of just compensation in light of the harm anticipated by the parties.[11] Second, the anticipated damages that may arise from the breach must be uncertain and difficult to calculate.[12]     

            By contrast, in civil law jurisdictions penalty clauses are generally enforceable.[13] In classic Roman law, for example, the stipulatio poenae was used as means of enforcing natural obligations that were not generally enforceable, such as obligations acquired by minors or the obligations arising from contracts that did not comply with legal formalities.[14]  Today most civil law jurisdictions continue to enforce penalty clauses, even those that may result in excessive money judgment vis-à-vis the actual damage caused to the non-breaching party. However, most civil jurisdictions grant the courts the discretion to reduce the penalty clause to a reasonable amount, but only if the promisors requests it.[15]  

            In Colombia, parties to a contract are generally allowed to enforce liquidated damages clauses, even if such damages amount to a penalty. Unlike in common law, if the penalty clause is grossly disproportionate when compared to the actual damages, the penalty clause is not declared void ab initio, but instead, it is adjusted by the court at the request of the debtor, or by the court itself depending on whether the contract involves a determinable or indeterminable consideration.[16]

             Moreover, under Colombian law, penalty clauses serve a variety of functions besides those generally associated with liquidated damages clauses in common law jurisdictions. This multifaceted role of the penalty clause and its active role under Colombian law will therefore be used as a starting point in the analysis.

 Pursuant to Article 1592 of the Colombian Civil Code, a penalty clause is a contractual clause whereby one of the parties agrees to perform, as a penalty, an obligation to give, do or not do something.[17]  It is said that the penalty clause serves three main functions: (i) breach deterrent; (ii) guarantee and (iii) damage prognosticator.

 

   A. The Penalty Clause as Breach Deterrent 

 Similarly to the stipulatio poenae in the classic Roman law and the old Spanish law, Article 1594 of the Colombian Civil Code allows a creditor to enforce both the underlying obligation and the penalty clause if the agreement entered by the parties so provides. [18] In these cases, the damages arising from the penalty clause may be recovered along with the compensatory damages arising from the breach of the underlying obligation. [19]

Colombian Civil Code also allows parties to negotiate penalty clauses in favor of third parties, what was known under classic Roman law as the rato manente pacto. [20]  In these cases, the penalty clause serves as breach deterrent in favor of third parties and not as a guarantee because generally a third party has no enforceable rights under an agreement. It is therefore said that the third party is entitled to enforce the penalty clause independently. [21]

Two examples may be instrumental in clarifying the foregoing. Assume that Parties A and B agree to sell/purchase widgets for 10,000. Both parties also agree on a penalty clause in favor of B. In this case, the penalty clause guarantees compliance of Party A with its obligations under the agreement.[22] Party B will be able to enforce both the penalty and request damages only if the contract so provides. By contrast, assume that Parties A and B agree on the penalty clause, but this time in favor of Party D, so that D will be compensated if Party A breaches his portion of the agreement (e.g. if Party A does not deliver the widgets). If Party A breaches, Party D will not be affected by the breach (since he does not have anything at stake in the agreement). The only person affected by the breach is Party B who may request an indemnification for the breach or request Party A to perform (depending on the case). Although not affected by the breach, Party D may enforce the penalty clause agreed in his favor even if Party D does not have any rights in the underlying agreement.[23] 

Complicating things, let us take a pragmatic example commonly present in insurance contracts. Assume Party A enters into an insurance agreement with Party B (an insurance company). Under the terms of the contract, Party A insures certain widgets to be delivered to D. The insurance is made in favor of D, who, although not a party to the insurance agreement would have the ultimate right to enforce the insurance agreement. Indeed, under the theory of estipulacion por otro, third party beneficiaries are entitled to enforce certain obligations of an agreement executed by others. It is said that Party D is the third-party beneficiary of the insurance agreement celebrated between A and B.

Now, assume further that in addition to the right of D to enforce the insurance agreement, Parties A and B establish a penalty clause in favor of Party A, who has no rights to enforce the insurance agreement. Party A will then be entitled to enforce the penalty clause of the insurance agreement if B does not pay. The enforceability of A’s right would therefore be independent of D’s right. This explains why the penalty clause should be construed as a breach deterrent, rather than as a guarantee. Indeed, Party B will be compelled to comply with the agreement (deter from breaching) not because of a guarantee given to D, but instead because of the fear of paying a penalty to a party that has no legal rights in the insurance agreement.

 B. Penalty Clause as a Contractual Guarantee [24]

Similarly to a pledge or a mortgage, penalty clauses guarantee the compliance of the underlying obligation.[25] In Roman times, this function acquired special preponderance in cases where the underlying obligation was unenforceable, not because it was void or null but because it did not give raise to a legally enforceable obligation e.g. obligations acquired by insane people or by minors. This function stayed in most civil law jurisdictions giving the creditor the right to enforce the guarantee against the third-party guarantor.

Under Colombian law, this function is only operative when a third party guarantees the underlying obligation of a debtor, [26] for instance if Party D agrees to guarantee Party A’s obligations arising from his agreement with Party B. In such cases, Party B (the creditor) has the possibility of either enforcing the underlying obligation against the debtor’s assets (Party’s A assets) or enforce the penalty clause against the third-party guarantor (Party D). [27]

This function departs from the role of penalty clause as breach deterrent in that in the latter the penalty clause and the right to enforce the underlying agreement does not fall in the same person.[28] By contrast, when the penalty clause is used as a contractual guarantee, the right to enforce the agreement or the penalty clause falls on the same person (B in the example below). It is, therefore, said that the penalty clause and the right to enforce the agreement are not independent but alternative (in the sense that the creditor has the alternative to enforce the contract or the guarantee).

  C.  Penalty Clause as a Damages Prognosticator 

The penalty clause also serves to anticipate the damages a non-breaching party may claim in the event of a breach.[29] This function is generally seen as the most important function of the penalty clause.[30]

Similarly to liquidated damages clauses, penalty clauses are used in civil law jurisdictions to anticipate the damages a party may incur for the breach of the other party.[31] Many scholars believe this to be the most efficient way to calculate damages, because parties, like no one else, are in the best position to estimate the scope of their damages.[32] 

Although this function is similar to the liquidated damages clauses regulated under the United States this function is broader in civil law jurisdictions because penalty clauses may be enforceable even if the underlying obligation is declared void.[33]

Let us take the Colombian example. Assume for example that Party A agrees with Party B that Party D will deliver the widgets. Under Colombian law, Party D is not obliged to deliver the widgets if he does not ratify said obligation.[34]  If Party D does not ratify, Party A will be in breach of a promise and Party B will be entitled to recover the damages caused.  Since promising on behalf of another person (when the promisor has no authority to do so) is a reprehensible conduct under Colombian law, vane promises are usually prevented and discouraged by the use of penalty clauses.

Going back to the same example, assume Party A promises Party B that Party D will deliver the widgets. Parties A and B additionally agree on a penalty clause to assure B that D will ratify. If D does not ratify (e.g. because he has given Party A no authority to negotiate) Party B may be entitled to recover the damages arising from the Party A’s promise plus the penalty agreed. This function works both as a deterrent of reprehensible conduct and as a guarantee of Party A’s promise. Note that since D did not ratify his obligation, no agreement was formed. This however, does not limit B’s ability to enforce the penalty clause against A.

 

D. Putting the Findings in Perspective 

Unlike liquidated damages clauses, penalty clauses serve a plurality of functions in Colombian law. As a result, the legal transplantation of the efficient breach hypothesis to Colombian law may create more discomfort in the commercial flow than benefit. However, an initial disruption of the legal order may be welcomed if said disruption is beneficial in the long run. The question that arises is therefore, whether the Colombian legal system should implement the efficient breach hypothesis as a means of promoting free and efficient commercial flow, or whether Colombian courts should disregard the efficient breach hypothesis In other words, is the Colombian penalty clause legislation efficient?

The main concern of the economists adhering to the efficient breach hypothesis is that the enforcement of penalty clauses deters efficient breaches.[35] This concern is both valid in the United States as well as in Colombia. Indeed, there is inefficiency when the anticipated damages are higher than the actual damages because, for example, a promisor would be compelled to perform even when the cost of performance exceeds the net benefits for each of the parties involved. [36]

Also, it said that penalty clauses create a barrier of entry. Thus, the efficient breach hypothesis suggests that limiting the amount that may be recovered from a contractual breach enhances efficiency as said limit prevents the parties from over committing to a specific agreement. [37] 

Another concern arises from the fact that scholars in the United States tend to see penalty clauses as the result of either unfairness in the bargaining process (for instance, as the result of adhesion contracts); or as an objectionable in terrorem agreement entered to secure performance overcompensating the injured party and obstructing the free commercial flow. [38]

In spite of these apparent problems, many scholars believe that limiting the amount of damages that can be recovered after a breach is not as efficient as initially thought. [39] Some critics even see anticipatory damages clause (e.g. liquidated damages or penalty clauses) as the most efficient way to calculate damages.[40]

 In the particular case of Colombia, where civil procedures are lengthy and where it is often hard to prove the actual damage caused, penalty clauses serve a threefold purpose. First, creditors are released from the task of proving the damages caused since there is a legal presumption that the amount agreed by the parties in the penalty clause is enforceable juris et jure, so that the debtor cannot present any evidence to the contrary. Article 1599 of Colombia’s civil code establishes this presumption by stating that the penalty may be enforced whenever it has been agreed upon by the parties without any kind of recourse by the debtor. [41]

Second, the penalty clause reduces the evidence stage of the procedure because, as stated above, the debtor is not entitled to prove that the damages caused were lower than originally anticipated. For example, if Party A causes a damage of 10,000 by not delivering the widgets but the penalty clause is set at 100,000, Party A will not be able to show that the actual damage was 10,000.

Lastly, the penalty clause may be automatically executed. Creditors enforcing a penalty clause are only required to show that the underlying obligation has been breach and that that a penalty clause is triggered as a result of such breach. [42] Creditors are therefore not obliged to enter into a lengthy procedure to execute the guarantee but would be automatically paid if the court finds there is a breach. In this sense, the role of the penalty clause is more efficient than other sorts of guarantees like a pledge or a mortgage that require an additional process to be executed. [43]

As seen, unlike the common law where liquidated damages play a limited role in the contractual relationship of two parties, the plurality of applications that penalty clauses have in a civil law jurisdiction implies a rejection of the efficient breach hypothesis. This, by no means, suggests that the contractual legal order of civil law jurisdictions is inefficient. On the contrary, it suggests the limited applicability of the hypothesis in countries where additional transactional costs, not common in common law jurisdictions, play a major role in the decision-making process.

 III.       AVOIDING COLOMBIAN LITIGATION: SEEKING EFFICIENCY ABOVE ALL 

The efficient breach hypothesis rests on the presumption that parties are willing to go to court. [44] The hypothesis assumes that parties are influenced by the contractual remedies established in the agreement when deciding whether to breach or not the contract. [45] But this assumption is only valid if non-breaching parties are able to go to court and obtain the damages they are entitled in an efficient manner, i.e. if there are no transaction costs resulting from going to court.

If the court systems is clogged by lengthy procedures, the transactional cost of litigating a breach in order to obtain recovery may encourage a party to carefully negotiate anticipatory damages in the form of penalty clauses as a means of either securing a faster recovery, as in the case of Colombian law, or as means of deterring the other party from breaching the contract.

Based on the current status of Colombian procedural law, particularly its lengthy stages and its clogged tribunals, [46] it is suggested that an ex-ante calculation of damages via penalty clauses would tend to be more efficient for the parties than implementing the teachings of the efficient breach hypothesis. Indeed, the Colombian procedural system is often, if not always, lengthy and tedious. [47] In common parlance it is said that the “live of a Colombian lawyer equals two complex litigations”. Establishing and negotiating penalty clauses in a contract is therefore an excellent mechanism to reduce the length of the process since the creditor is not obliged to show the actual damaged caused, but simply, to show that there was a breach of the contract and that the penalty clause was triggered with said breach. [48] 

On the other hand, penalty clauses can be used as a sort of “insurance” to secure performance. Proponents of the insurance theory argue that in the absence of unfairness or other bargaining abnormalities, efficiency is maximized by the enforcement of the agreed allocation of risks embodied in a liquidated damages clause. [49] This theory suggests that liquidated damages secure transaction costs because the cost of negotiating a liquidated damages clause (or a penalty clause) are less than the costs of litigation.  

The theory is also expressed by Hatzis in the following terms: when one of the parties is risk-averse and/or places high subjective valuation on the performance of the contract, and the other party is the best possible insurer against his loss, then it is logical to ensure performance by establishing a penalty (“insurance”). [50] On this perspective, penalty clauses are preferable than an insurance contract in various grounds:

 (i)        They are less costly, both economically as in terms of opportunity costs;

(ii)        They facilitate the calculation of risks since they eliminate uncertainty in the future as to the amount that will be recovered at the same time;

(iii)       They promote contract planning as parties know with certainty what they would recover/pay in the event of a breach;  

(iv)       Insurance compensation generally does not contemplate the recovery of non-pecuniary damages, as it is sometimes done with penalty clauses; and

(v)        Subjective valuation can be expressed in the penalty clause (e.g. in the form of a greater penalty) which is not often the case in insurance agreements absent a greater premium. [51]

Thus, absent abnormalities in the negotiation process it is suggested that the use of penalty clauses under Colombian law would achieve higher levels of efficiency by imposing anti-breaching mechanisms that guarantee performance of the agreement.

  

IV.       CONCLUSION        

 

Analyzing law through the eyes of economists usually brings innovative solutions and new perspectives to recurrent legal problems. Yet, said analysis must take into consideration the realities of the law and its formalisms. While in some cases it would be possible to permeate the law with innovative economic perspectives, in others, the economic perspectives have to give way to legal traditions, which although not economically viable, if analyzed alone, allow the legal system to function efficiently when analyzed in conjunction with other institutions.

Although innovative, the applicability of the efficient breach hypothesis to Colombian law is limited. Not only does it conflict with important institutions of Colombian law like the penalty clause; but also, disregards pragmatic problems related to the current state of Colombian legal proceedings.

Despite the limit applicability of the efficient breach hypothesis, it is the hope of this author, that some of the teachings of economic analysis be borrowed by Colombian scholars and that this paper becomes a tool to foster a new wave of thinking outside the box, that will not only strengthen Colombia’s legal institutions but also, enrich and modernize the way law is analyzed, viewed and practiced there.

 

*          *          *



[1] See  Walgreen Co. v. Sara Creek Property Co., 966 F.2d 273 (7th Cir. 1992) (Posner, J., dissenting).
[2] Allan Farnsworth et. al. Contracts Cases and Materials, 7 (Ed. Foundation Press, 2001) 1965.
[3] Barry E. Adler, Efficient Breach Theory Through the Looking Glass, 83 N.Y.U. L.Rev. 1679, 1688 (2008) (arguing that negative damages may promote efficient breach decisions ex post and efficient investment decisions ex ante).
[4] Jody S. Kraus, A Critique to the Efficient Performance Hypothesis, Yale L.J. Pocket part 568 (2006) (criticizing the efficient breach hypothesis while offering an alternative theory defined as the efficient performance hypothesis).
[5] Adler, supra note 3 at 1681.
[6] See Patton v. Mid-Continent Systems, Inc., 841 F.2d 742 (7th Cir. 1988) (discussing the efficient breach and the importance of remedies in the decision between performance and breach).
[7]  I disagree with Judge’s Posner characterizing civil law as inferior from the standpoint of promoting commercial activity. See Richard A. Posner, Let Us Never Blame A Contract Breaker, 107 Mich. L. Rev. 1349, 1352 (2009) (criticizing that the concepts of fault and blame, as understood of moral terms, as unlike components to the doctrine of contract law).
[8] See Metz v. Clay 101 Kan. 45 (1917); McGrath Co v. Wisner, 55 A.2d 793 (Md. 1947); City of Rye v. Public Serv. Mut. Ins. Co., 315 N.E. 2d 458 (N.Y. 1974).
[9] Charles J. Goetz et.al., Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach, Colum. L. Rev. 554, 555 (1977) (discusssing the principles of just compensation and efficient breach).
[10] Aristides N. Hatzis, Having the Cake and Eating it Too: Efficient Penalty Clauses in Common and Civil Law Contract Law, Int’l Rev. l. & Econ. 381, 385-86 (2002) (discussing the different approaches of Common Law and Civil Law vis-à-vis liquidated damages).
[11] See Restament 2nd of Contracts § 356 and U.C.C. § 2-718(1).
[12] Id.
[13] Id.
[14] Guillermo Ospina Férnandez, Rérgimen General de las Obligaciones, 132 ( Ed. Temis S.A. 1998) (1992).
[15] See for example the Spanish civil code (Art. 1154 of the Spanish Civil Code); the Italian civil code  (Art. 1382-1384 of the Italian civil code).
[16] See Cód. Civ. Article 1601.
[17] See Cód. Civ. Article 1592.
[18] See Cód. Civ. Article 1600 generally prohibits the enforcement of the penalty clauses when damages have been requested. However, the penalty and the damages may be aggregated if the agreement so provides. 
[19] Ospina Férnandez, supra note 14 at 142.
[20] See Cód. Civ. Article 1502.  
[21] See Cód. Civ. Article 1506.

 

[22] See infra Part II B. 
[23] See Cód. Civ. Article 1593.
[24] See Cód. Civ. Article 65.
[25] See Cód. Civ. Article 1502.
[26] See Cód. Civ. Article 1529.
[27] Ospina Férnandez, supra note 14 at 144.

 

[28] Id.

[29] See Cód. Civ. Article 1593.

[30] Id.  
[31] See Cód. Civ. Article 1502.
  
[32] Hatzis, supra note 10 at 390 
[33] See Cód. Civ. Article 1507.
[34] Id.
[35] Patton v. Mid-Continent Systems, Inc., 841 F.2d 742 at. 745
[36] Hatzis, supra note 10 at 385.
[37] Id.
[38] Goetz, supra note 9 at 562.
[39] Id. at 561.
[40] Hatzis, supra note 10 at 390.
[41] Cód. Civ. Article 1601.
[42] Cód. Civ. Article 1599.
[43] Ospina Férnandez, supra note 14 at 146.
[44] Ni Zhu, Case Study of Legal Transplant: The Possibility of Efficient Breach in China, 36 Geo. J. Int’l L. 1145, 1146 (2005) (discussing the applicability of the efficient breach hypothesis in China).
[45] Id.
[46] See Omar Beabentos et. al, Derecho Procesal, Civil y Comercial, 137 (Ed. Juris, 2004).
[47] Francisco Leal Buitrago, En lA Encrucijada: Colombia en el Siglo XXI,  459 ( Ed. Norma, 2006).
[48] Similarly, the threat of a subsequent review increases the costs of negotiating the damages clauses.
[49] Goetz, supra note 9 at 578.
[50] Hatzis, supra note at 10 at 391.
[51] Id.

 

 

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