2004 Articles

Embedded Options and the Case Against Compensation in Contract Law

Scott, Robert E.; Triantis, George G.

Although compensation is the governing principle in contract law remedies, it has tenuous historical, economic, and empirical support. A promisor'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 insurance to their buyers in the form of these embedded call options, and that termination fees, including damages, are in essence option prices. Furthermore, 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 tantamount to price regulation -- a function outside the realm of contract law. Moreover, in light of the generosity among optimal option prices, this Article 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 break damages, by the threat of specific performance of their contemplation exchange or, in the case of consumers, by a default rule that provides them a termination option at no cost.