The Law of Restitution for Void Contracts: An Economic Analysis

Abstract

This paper develops an economic analysis of the application of the law of restitution to the case of void contracts, when agreements may be unenforceable due to legal invalidity. It develops a simple model in which contracting parties’ agreements potentially impose external harms. The analysis focuses on how alternative restitution regimes affect contracting incentives when there is a possibility that agreements may turn out to be unenforceable. A central insight is that in a setting in which contract invalidity is possible, contracting requires not merely that the parties’ joint surplus is positive but also that a participation constraint is satisfied for each party (as there are states of the world in which the parties cannot redistribute the surplus between themselves). We show that full restitution can induce socially excessive contracting, while the denial of restitution can inefficiently deter welfare-enhancing transactions. A regime of partial restitution can potentially implement first-best outcomes by calibrating parties’ incentives to the probability and magnitude of potential external harms. In essence, this regime can serve as a substitute for a Pigovian tax on the contracting parties. The paper discusses applications of this framework to the interest rate swap cases of the 1990s and to other contexts.