The Case for Punitive Damages in Contracts

Abstract

The majority of American jurisdictions do not allow punitive damages for breach of contract unless the breach constitutes an independent tort. Increasingly, courts and commentators have relied on the theory of “efficient breach” to explain the rule against punitive damages in contracts. In this Article, Professor Dodge argues that economic efficiency supports a different rule — one allowing punitive damages for any willful breach of contract.Willful breaches fall into two categories: those that are “opportunistic” and those that are “efficient.” An “opportunistic” breach does not increase the size of the economic pie; the breaching party gains simply by capturing a larger share of the pie at the expense of the nonbreaching party. An “efficient” breach, by contrast, increases the size of the pie, allowing the breaching party to compensate the nonbreaching party and still come out ahead. Deterring opportunistic breaches with the threat of punitive damages is efficient because such breaches by definition do not increase societal wealth. Thus, punitive damages should be routinely available in cases of opportunistic breach, such as pretextual termination, stonewalling, and bad faith refusal to pay a debt.Efficiency also supports extending liability for punitive damages to those breaches that are, in theory, “efficient.” The threat of punitive damages will not require inefficient performance because the potentially breaching party may negotiate with the other party for a release. Relying on Calabresi and Melamed’s distinction between “property rules” and “liability rules,” Professor Dodge shows that requiring the potentially breaching party to negotiate for a release is more efficient than allowing her to breach and pay damages because the transaction costs of negotiation, while not negligible, are generally lower than the assessment costs of litigation. He also explains why other forms of “property rule” protection, like specific performance and penalty clauses, are insufficient to ensure that negotiation occurs before breach.