Substituting Invalid Contract Terms: Theory and Empirics (with Ori Katz)

The law often lays down mandatory rules, from which the parties may deviate in favor of one party (e.g., the consumer, tenant, or employee) but not the other (e.g., the supplier, landlord, or employer). Examples include the invalidation of unreasonably large liquidated damages; the unenforceability of excessive non-compete clauses in employment contracts; and the doctrine of unconscionability. In these cases, the law may substitute the invalid term with a reasonable, moderate arrangement; with a punitive arrangement that strongly favors the protected party; or with a minimally tolerable arrangement (MTA), which preserves the original term as much as is tolerable.
The article revisits the choice between the various substitutes. Based on theoretical analysis and a series of new empirical studies, it argues that the incidence of MTAs should be rather limited. It demonstrates that people tend to find moderate substitute arrangements more attractive than either penalty arrangements or MTAs. It also points to two overlooked incentive effects of the substitute arrangement (in addition to its impact on the drafting of contracts). First, the applicable substitute strongly influences customers’ inclination to challenge excessive contract terms once a dispute arises—not only due to the different expected payoffs under each substitute, but also due to their varying expressive effects. Second, when the invalidation of an excessive term is discretionary, the applicable substitute can affect decision-makers’ inclination to invalidate excessive clauses in the first place in surprising ways. The article concludes that the case for MTA substitutes is considerably weaker than previously claimed.