Substituting Invalid Contract Terms: Theory and Preliminary Empirical Findings

Abstract

The law often lays down mandatory rules, from which the parties may deviate in favor of one party but not the other. Examples include the invalidation of high liquidated damages and the unenforceability of excessive non-compete clauses in employment contracts. In these cases, the law may substitute the invalid term with a 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 find moderate substitute arrangements more attractive than the alternatives. 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. 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.

Keywords: mandatory rules, contract law, substitute arrangement, minimally tolerable arrangement, judicial discretion, consumer contracts, exemption clauses

JEL Classification: K, K12, K41