The Economics of Contract Law Deterrence and Public Law Deterrence in Illegal Contracts

A working paper with Teng Wang.

ube-k-pubpolicy

Source: New York Bar Picture Book.

The illegality of contract is a universal topic in the contract law of major jurisdictions. Under the doctrine of illegality, contract law rules have long been used as a deterrent instrument to effectuate public policy concerns. This paper sets out to analyse the relationship and interaction of contract law deterrence and public law deterrence under the framework of illegality. We employ a utility theory and establish an economic model of deterrence.

Three scenarios are categorised. In the first scenario, it is assumed that both parties knew or should have known the illegality of the contract they entered into; and both parties are homogeneous in their reactions to contract law deterrence. To achieve optimal deterrence, the court or arbitral tribunal should always declare an illegal contract ineffective and refuse restitution. In the second scenario, it is assumed that one party did not know and should not have known the illegality, while the other party knew the illegality. To achieve optimal deterrence, the court or arbitral tribunal should always declare an illegal contract ineffective and grant unilateral restitution to the party who did not know and should not have known the illegality. In the third scenario, it is assumed that both parties knew or should have known the illegality; and the parties’ reactions to contract law deterrence is heterogeneous. If the damage occurred to the party who is less possible to be deterred (party B) is bigger than the benefit the other party has transferred, then the decision or award declaring the contract partially effective and granting unilateral right to enforcement to party B will achieve optimal deterrence. If the damage is less than the benefit the other party has transferred, then the decision or award declaring the contract ineffective and granting unilateral right to restitution to party B will achieve optimal deterrence.

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