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Substituting Invalid Contract Terms: Theory and Preliminary Empirical Findings

Eyal Zamir and Ori Katz

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, the unenforceability of excessive non-compete clauses in employment contracts, and caps on interest rates in loans. 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 new empirical studies, it argues that the previous literature, which focused on the incentives the substitute arrangement creates for the drafting of contracts, overlooked two other important incentives. 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. Once the two additional incentives are considered, the emerging picture is considerably more complex, and the case for MTAs is weaker.

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