The Implications of the Contract Clause: Protecting the Right to Private Contracts

Contract Clause

The right to create and hold a contract clause has been enumerated in the United States Constitution since the beginning. Contained in Article 1, Section 10, the clause known as the contract clause has become one of the constitutional provisions that seem minor but have had a more significant impact on the jurisprudence of the United States.

The Founders acknowledged the right to enforce contractual obligations within the states without worrying that individual states could make laws that interfered with private contracts was vital to the wellbeing of the fledgling nation. Because this right has been codified in the Constitution, the states are barred from interfering with a contractual relationship, and such legislation will be challenged under constitutional law.

This article will explore the Contract Clause and the impact that it has on alternative dispute resolution. We will begin by examining the Contract Clause itself and how it is defined. Next, we will look at how the law impacts both state law and the federal government. After gaining an understanding of the clause, we will explore the contract clause jurisprudence and how the federal courts exercising jurisdiction over the cases decide the issues surrounding the implementation of the contract clause.

Finally, after gaining a thorough understanding of what the contract clause is and how a contract clause challenge may be decided, we will discuss the implications of the contract clause on the alternative dispute resolution field and how it may enforce or impact existing contract rights.

The Text of the Contract Clause

As stated above, the Contract Clause is a part of Article 1, Section 10, Clause 1 of the United States Constitution. The larger clause surrounding the Contract Clause is a general prohibition against the states and regulates the powers that the states have in relation to the federal government. The full clause read, with special emphasis on the contract clause itself:

“No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.”

This clause as a whole helps the states understand the role that they have in the government of the United States as a whole, with the emphasis for this article falling on the prohibition of interference with contracts.

The other prohibitions contained in this clause help outline the role of the states further and prohibit them from creating ex post facto laws, bills of attainder, currency, and other laws within the state legislature. Therefore, this clause is considered a prohibitive clause, protecting the rights of individuals against the states and the federal government from interference from the states.

History of the Contracts Clause

According to Chief Justice John Marshall, the Contracts Clause was created as a direct answer to the practice of the colonies in creating laws to modify existing contract rights in favor of debtors. Under the Articles of Confederation, many states had enacted laws that favored domestic debtors over foreign creditors, especially when a debtor sought escape from the obligation of a contract.

According to the Court, the authors of the Constitution viewed this practice as a direct challenge to commerce and bad faith. It discouraged other nations from extending credit to the United States and colonies and undermined the fledgling economies of the states. Therefore, by imposing a prohibition on state law that would favor domestic debtors and stop the states from directly interfering with existing contracts, the Contract Clause would ensure that the new economy could stand on its own.

What Would a “Law Impairing the Obligation of Contracts” Look Like?

To understand the impacts of the contract clause, it is important to understand the definitions that make up the various components of the law. Many of these definitions have been shaped and impacted by the various court cases that have impacted the law, but the main tenets of the definition of the contract clause’s protections have remained the same throughout time. These components include a definition of what laws are prohibited, the obligation of contracts, and how a law impairs the obligations.

Definition of Law

Because the contract clause prohibits the states from creating a law impairing the obligations of contracts, it is important to understand what the legislatures and the courts have determined the word law to mean. The most common definition of a law is a statute that a state legislature passes and is added to the statute books. While this is the most common definition of a law, several other forms of the law are considered among the formal and acknowledged methods of creating law. We have to go beyond what natural law tells us a law is and explore all the various meanings of laws.

The first type of law is the one mentioned above, which is a statute passed through the state legislature and becomes state law. These laws are written out and have been agreed upon by at least a majority of representatives and signed by the governor. They are the basis for the way the government functions and funds itself and its programs within a state. State legislation would almost always be considered a law.

Another common form of law that may be considered part of the definition is a constitutional provision. Constitutional provisions are parts of the state or federal constitution that affect the way a government sets up the various roles at play and how the various branches interact with each other. Most constitutional provisions will remain the same from when the states were formed; however, different states have ways to shape or add constitutional provisions when needed or necessary.

Ordinances are another form of law that govern a smaller area within a state, usually a town. Most towns and cities will have municipal ordinance codes that outline the way that a city will regulate its business. Most of these municipal laws revolve around zoning, parking, and noise laws.

These can change frequently, and some may be challenged by the contracts clause if they interfere with the right of certain people to make and hold contracts. Additionally, many states will have contract clauses contained in a state constitutional prohibition to stop municipalities from creating a law impairing contracts.

Definition of Regulation

Regulations are the final form of the most common laws that could be impacted in a contract clause challenge. Regulations are created by state and federal agencies that carry out a specific task given to them by the executive branch of the government. For example, the Federal Food and Drug Administration (FDA), creates regulations around the foods and prescriptions that people can consume. Many states also have agencies that regulate certain tasks that are given to them, and these state regulations could impact the contract clause.

While the options above are considered formal law, there is a question about whether judicial decisions by the courts can be considered law to comply with the Contract Clause. Judges have long held that they do not create law but instead interpret existing laws, meaning that the decisions they issue cannot be considered law for a contract clause challenge.

However, the practice of many judges has evolved to include more decisions that can sometimes create law in the way that a statute or regulation is interpreted. Therefore, many scholars will place judicial decisions in a gray space between law and opinion, but they are usually excluded from contract clause challenges.

Definition of Obligation

The phrase “obligation of contracts” contained in the contract clause has been a topic of some discussion and debate. Within a standard understanding of a contract, there are two separate elements–the agreement and the obligation. The agreement is the formation of the contract between the parties, to exchange services or goods for money or other goods. The obligation of contracts is the responsibility to perform the work or exchange the goods. This means that many contracts are in existence that the agreement, yet the obligation has not been fulfilled.

This distinction between the agreement and obligation of contracts has caused disagreement in the interpretation of the contract clause. Many people believe that the original intent was to only prohibit laws that interfere with contracts that are currently in existence yet not fulfilled. This is how Chief Justice Marshall defined the phrase in his early opinions.

This was the early understanding of the clause, but it has evolved to also include a constitutional prohibition against a law that impairs contracts regardless of the stage the contract is in. Since Chief Justice Marshall’s definition did not contain the clarity and exactness to define what the prohibition entailed. The courts tend to move back and forth between including and excluding the agreement section in the definition.

Definition of Imparing

It is also important to understand how a law may impair the obligation of contracts and therefore violate the Contract Clause. At the same time, the clause seems to be broad enough to prohibit any state law that interferes with the aspects of contracts. However, the Courts have limited the impact of the Contract Clause to any state law that would interfere with the state’s obligations under its own contracts or that would interfere with private contract rights. This helps lessen the burden on the states and stops state law from being constricted more than possible.

The seminal case for understanding the current definition of impairing the obligation of a contract comes from Chief Justice Hughes in Home Building & Loan Ass’n v. Blaisdell. In this case, Hughes states that a law impairing the obligation of contracts is one that invalidates, releases, or extinguishes the rights found under a contract. He further explains that a law that impairs contracts may not fully eliminate the contract, but the application of the law would affect substantial contractual rights.

When taking all definitions together, the Contract Clause can be defined to prohibit the states and other powers within the states from enacting laws that either extinguish or significantly impede substantial contract rights, which may be both in the agreement stage and the performance stage. This definition will be expanded further as we explore the various court decisions that have had a direct impact on how various courts have ruled on the application and definition of the contract clause.

The Impacts on Government

Before diving further into the past and present treatment of the Contract Clause, it can also be helpful to look at how the clause can impact the work of government and how it can shift the ways governments need to do business. While it may seem like the law is protecting its citizens or carrying out an important need in the state, governments must be careful not to run afoul of the Contract Clause and create a state law that could be considered unconstitutional.

The Federal Government

The Contract Clause, because it is contained within the prohibitions of the states, does not have a direct impact on the federal government. The federal government is actually not barred from interfering with the obligations of contracts in the same way that the states are.

However, the Contract Clause can cause the federal government to act when the states have had significant issues with the imposition or obligations of contracts and they ask the federal government to step in to protect citizens. This can either happen through interpretation in the Supreme Court or through new legislation in the federal government.

State Governments

The major impact of the Contract Clause is felt by the states and the governments within them. Under the Clause, states are barred from creating state law, state regulation, or other forms of law that impair contracts. This means that every piece of state legislation must be run through a rigorous review to determine the impact the law would have on private contract rights.

This analysis is further complicated by opinions and decisions of the courts that allow the state to enact legislation to protect residents and how the impact is challenged when the state legislation may interfere or alter its own obligations under contracts.

How the Supreme Court Interprets the Contract Clause

For a few words contained in a more robust clause of the Constitution, the Contract Clause has faced many challenges and judicial decisions throughout history. These cases that have challenged state authority to create laws that may interfere with private contract rights have included more questions.

Notable Contact Clause Cases

Including whether state contracts were included in the definition of the contract clause, the ability of states to modify contracts, whether remedies afforded under a contract would be protected, and the interaction between state police power and private contracts. This section will dive into some notable cases and outline the way the Court ruled, both for state contracts and private contracts.

Fletcher v. Peck, 10 U.S. 87 (1810)

This is one of the first cases to use the Contract Clause to effectively challenge state legislation. At the center of this case was a conveyance of land from one party to the other. The original owner had gotten the land as a part of an act of the Georgia Legislature to control land seized from indigenous people.

After the conveyance, the Georgia Legislature passed a law that voided all contracts for the land seized, claiming that it was done through trickery. This voided the original owners’ contracts and caused many conveyances to be invalid. The case was brought to challenge this law and any action taken by either party as a result.

The landmark decision held that the state legislation voiding all contracts for the land was invalid under the contract clause. It stated that because the conveyance and sale of the land was a contract, the legislature could not invalidate it, even if the land was gained illegally.

This cemented the Contract Clause’s place as a strong prohibition against the states and a protector of the individual’s rights to contract. Additionally, it stated that legislation could not invalidate contracts made by the states, expanding from private contract rights to include contracts involving the state as a party.

Trustees of Dartmouth College v. Woodward, 17 U.S. 518 (1819)

This case outlined the role of the Contract Clause as it relates to private contracts. The case was brought in response to a New Hampshire law and decision that effectively converted Dartmouth College from a private college to a public college through a series of changes to the charter of the college. Dartmouth had originally been created by a charter from King George while New Hampshire was still part of the British colonies. The college sued to stop the conversion and overturn the legislation that forced the conversion.

The Court ruled in favor of the college, stating that although the original charter was done by a foreign state, it still was a contract for the purposes of legal classification, meaning that the state could not create legislation that interfered with the college’s obligations and rights under the contract.

This ensured that the Contract Clause not only protected contracts where the state was a party but also protected the rights of those in private contracts, even those that were created under state law, opening the door to more challenges to the authority of states when considering contract rights in legislation.

Sturges v. Crowninshield, 17 U.S. 122 (1819)

The question in this case was whether the new New York laws on bankruptcy would be a law that interfered with the obligation of contracts when applied retroactively. New York had recently passed bankruptcy laws that established a procedure for bankruptcy. It also applied these laws retroactively, letting people challenge or excuse debts that had been incurred before the laws had been passed. Several people challenged the laws as they applied.

The Court ruled against the retroactive application of the law clause, stating that the law would interfere with the contracts created before the laws. The Court ruled unanimously on this issue, as it was clear that the laws would not have been a part of the meeting of the minds that the parties would have reached in the contract. This cemented that a fully private contract was also protected from interference by further state action.

Ogden v. Saunders, 25 U.S. 213 (1827)

This case determined a question the Supreme Court had left open in Sturges. In this case, two private citizens entered into a contract after the New York bankruptcy laws were in effect. Later, Saunders sued Ogden, stating that he had not paid on the contract. Ogden then used bankruptcy as a defense to the obligation under the contract, which would allow him to discharge his obligation. Saunders raised the question of whether the bankruptcy laws violated the Contract Clause because they interfered with the obligations of their contract.

The Supreme Court’s interpretation of the bankruptcy laws found that the laws did not violate the Contract Clause. The Court found that such a contract entered into after the laws were passed would be made in consideration of the laws applying to the contract. This means that the laws did not interfere with the obligations of the contract because the contract had been made with those laws applying to it.

This was an important distinction for many later challenges to legislation under the Contract Clause because it differentiated between laws that abridge existing contractual relationships and those that abridge contractual relations before the relationship begins.

West River Bridge Co v. Dix, 47 U.S. 507 (1848)

The outcome of this case requires a brief mention because it was one of the first cases that recognized that while the states cannot interfere with the obligations of contracts, the right of states to protect citizens and exercise other powers cannot be completely disregarded. This case questioned whether a bridge that was owned by a company through a state charter could be condemned and made into a private road.

The Court found that while the Contract Clause does give the parties the right to contract, the right. is still subject to the rights of the states, such as eminent domain. In doing so, the Court began to balance the prohibitions on the states with the rights of the states.

Charles River Bridge v. Warren Bridge, 36 U.S. 420 (1837)

This case acknowledged the state’s use of the police power to override contracts that would otherwise be protected under the Contract Clause. It also was received with varying responses by legal scholars and others. The issue, in this case, is whether a state charter granting the company permission to build and operate a toll bridge for 40 years, which was later extended to 70 years, could be subsequently modified by the charter for another very similar bridge to be built and only collect tolls to pay off the construction costs.

The original bridge stated that the new charter was not allowed under the Contract Clause because it modified their original contract.

The court sided with the new bridge company, Warren Bridge. One of the arguments in favor of the new charter was that the original toll bridge had far surpassed the costs of construction and many of the stockholders were making large amounts of money off the tolls. This caused public disdain for the continued use of tolls on the bridge connecting two vital parts of Boston.

The Court found that the new charter did not interfere with contract rights because the Court had to assume that the original charter was never a grant of exclusive rights, only a right to use. Therefore, because the state was using its police power to protect the good of the public and the economy to create competition, it was within the state’s power to do so.

Home Building & Loan Association v. Blaisdell, 290 U.S. 398 (1934)

This case, which was briefly mentioned above, was decided by a closely divided court and outlined the role of emergencies in the use of police power to override the contract clause. During the Great Depression, Minnesota passed a law that extended the redemption period for homeowners in the foreclosure process.

The rationale was to curb the ever-growing number of foreclosures happening in the state. This was challenged by a person seeking to collect on a mortgage that was currently in foreclosure, claiming that the law interfered with private property rights and the ability to contract.

The Court decided the case by a narrow 5-4 margin, stating that the emergency caused by the Great Depression justified the state’s use of emergency powers to modify the contracts that had previously been executed. In doing so, the Court expanded the state’s ability to use the police power and emergency issues to overcome the Contract Clause. It was also the first decision that allowed the states. to use a purely economic argument in conjunction with the emergency power.

The case also created a balancing test between the private contract rights and the need for the state to protect the good of all. The Court held that the states have a right to interfere with contracts when there is a public necessity that outweighs the rights to contracts so long as the law is reasonably tailored to achieve the end the state uses to justify the interference. The law in this case, the Court found, was reasonably tailored to directly impact the emergency that Minnesota had cited in creating the law.

Before this decision, the Court had upheld the power of the Contract Clause and had consistently struck down state law authorizing interference with private contracts, so this was a major shift in the jurisprudence of the Court. It was received with mixed reviews, with many arguing that it minimized private property rights.

United States Trust Company of New York v. New Jersey, 431 US 1 (1977)

One of the biggest shifts in the way the Court handled and determined state legislation concerning the Contract Clause, happened in the United States Trust Company of New York v. New Jersey. This case arose out of a contract between New York and New Jersey that created a Port Authority to monitor traffic between the two states.

The port authority’s discretion in the use of the income and profits from state, municipal, or county bonds, and both New York and New Jersey created laws to repeal the limitation and allow the port authority to subsidize rail traffic over automobile traffic. The bondholders sued the state, stating that the repeal of the contract creating the limitation violated the Contract Clause.

The Court held in favor of the bondholders, applying a heightened level of scrutiny to such legislation that seeks to modify a public contract. The states attempted to argue that the increased traffic caused by soaring populations in the metropolitan area justified the need for subsidization of rail traffic as the congestion was an emergency.

The Court rejected the otherwise legitimate police power because the Supreme Court found that the states had ample time and warning to create a system that addressed the situation before they had even entered into the agreement in question. The Supreme Court construed the contractual obligations where states are involved to be held to a greater level of scrutiny than those in private contracts. This separated public and private contracts in a way that had not been spelled out before and applied separate standards to each.

Allied Structural Steel Co. v. Spannaus, 438 US 234 (1978)

The Court further refined the Contract Clause jurisprudence in this case, which dealt with a Minnesota law requiring employers to pay the state if they closed their offices in the state without giving employees the money required under employer pension plans. The state claimed that it had enacted the law to address the public need that was often created when pensions were not paid out.

Allied Structural Steel, a company that had closed its office in the state and was forced to pay $185,000 to the state even though their employment contracts did not require such pension payments, asked the Supreme Court to issue a decision based on the Contract Clause.

The Supreme Court found that the state could not require such payments and interfere with the contracts between the private parties through this law and struck it down. While the state had raised a claim that they had acted within the police powers to create the law, the Court found that the law was too narrow in the entities that it applied to and did not achieve the aim of the state.

The law, the Court found, did not address a large-scale need, but a small subset of need that was created when companies closed without paying out their full pensions and did so in a way that required new and retroactive obligations placed on the companies. This helped the same court to address the limits of state power to impact the contractual obligations.

Energy Reserves Group v. Kansas P. & L. Co., 459 U.S. 400 (1983)

In this case, the Supreme Court examined the test for claims that a law interferes with a private contractual relationship. The contract at the center of the case was between two private companies in Kansas for the sale of natural gas between the two parties. The parties agreed to contract clauses that changed the price of natural gas to the price fixed by the government if it was higher. However, a Kansas state law barred the parties from basing the price of natural gas on a fixed price. The parties brought the law to the Supreme Court for review.

The Court found that the state regulation did not violate the Contract Clause. While the regulation may interfere with the terms of the contract as the parties had agreed, the court found that there was significant public interest in protecting against rate increases, so the law could stand. In the analysis of the case and the law, the Court created a three-part test to determine if state laws violate the Contract Clause when protecting a public interest under the police powers.

To pass this test, the law must not substantially interfere with the obligations, the rationale must be a significant and legitimate public interest that is broadly applicable, and the law must be reasonably appropriate for its intended use. This test is still frequently used today and is very similar to the rational basis test used in much of contract law.

Exxon Corp. v. Eagerton, 462 US 176 (1983)

The Court continued its rational basis test to evaluate whether a state law that impacted private contract rights could still exist to serve a broader public benefit. In Exxon, natural gas companies sued the state of Alabama after they enacted a law that increased certain taxes on the producers but did not allow the producers to pass that cost to the consumers. The companies alleged that the passthrough portion of the law violated their contract rights with the consumers.

The state argued that the law protected consumers from unfair rate hikes when the companies could absorb the cost elsewhere.

The Court ruled that the state retains adequate authority to enact laws that minimally interfere with private contracts when they are reasonably related to the protection of a public interest. Here, the Court compared the passthrough provisions of the law to rate fixing measures, stating that the state could protect the public from unfair business contracts and practices by not allowing the companies to passthrough costs. It found that the law applied broadly, had a legitimate public purpose, and the actions were reasonably related to the public benefit.

Keystone Bituminous Coal Ass’n v. DeBenedictis, 480 U.S. 470 (1987)

To move away from purely economic interests that the Court has found to justify interference with contracts, this case determined that a state’s interest in the safety and wellbeing of its residents was a proper justification for interference with contractual obligations.

This case challenged a Pennsylvania law that prohibited mining that would damage existing structures by removing supports from underneath. Several mining companies challenged this law, stating that it interfered with the liability risks in the contracts that the surface owners accepted as a part of their contract. The state argued that it had an interest in public safety, land conservation, and other justifications.

The Court sided with the state, stating that although the law did nullify the waivers of liability that the coal companies had been able to get from the surface owners; however, the state’s interest in avoiding environmental damage and harm to people and their buildings outweighed this interest. This is more consistent with the public idea that the justification should be for public benefit and safety, and the Court recognized that other protections justify such vastly important consequences on contract rights.

Sveen v. Melin, 584 U.S. ___ (2018)

In this recent decision, the Court clarified that not all laws that impact pre-existing contracts violate the Contract Clause. Such law was examined in this case questioning a Minnesota law that terminated an ex-spouse’s interest as a revocable beneficiary of a life insurance policy upon the issuance of divorce. The former wife and the couple’s children sued to recover the profits of the life insurance policy, stating that the law violated the contract rights of the beneficiaries and the policyholder.

The state supported the law by claiming that it asserted a public benefit by ensuring that the goals and wishes of the policyholder would be honored.

The Court upheld the law, stating that the policy was a contract for analysis, but retroactive application of the law to a contract does not automatically violate the Contract Clause. Justice Kagen wrote that a violation will only occur when the retroactive application significantly impacts the obligations, and it was not a reasonable and proportionate way to enforce “a significant and legitimate public purpose.” This clarified whether the retroactive application was automatically invalid and expanded the state’s use of police power,

Fourteenth Amendment

The ratification of the Fourteenth Amendment did impact the Court’s jurisprudence when it came to the Contract Clause. The Court noted that before the ratification, the only way to assert many private rights was under the Contract Clause and other state prohibitions. However, the Fourteenth Amendment provided a way for private citizens to assert private rights under the Equal Protection Clause, especially as their rights related to the states and government action. This is where the shift in the cases happened in the middle of the twentieth century.

The Impact and Implication of the Contract Clause on ADR

With this robust understanding of the Contract Clause and the way that the Supreme Court construed its application and use, it can be helpful to also consider the implications that this clause may have on alternative dispute resolution and the way that parties contract for their rights.

Because many of the agreements for alternative dispute resolution are created in contracts, it may be appropriate to challenge state legislation or civil law that impacts the right to participate in the dispute resolution of your choosing. There are several ways that alternative dispute resolution contracts may be impacted.

First, it would be possible that a contract to arbitrate or mediate a dispute could be impacted by a law that challenges such a contract. This could be a law that directly or indirectly interferes with such contracts, such as a law that makes it illegal to arbitrate employment disputes and retroactively applies such a law. This law could be challenged in several court cases by employers and employees who would prefer to arbitrate their disputes, and would likely be struck down.

However, it could make arbitrators and parties wary of arbitrating disputes while the cases are working their way through the system, especially if the state is asserting a public policy argument.

Second, states may create such legislation under a public benefit argument because many people have strong feelings against arbitration, especially when the arbitration clause is not adequately bargained for. Several states have created laws that make it illegal for certain types of disputes to be forced to arbitration through contracts of adhesion.

While this may impact federal law governing arbitration, it also may be challenged under the Contract Clause. These types of laws may continue to be challenged in state and federal courts until the Supreme Court or other courts make the final decision.

Final Thoughts

The Contact Clause prohibits states from creating laws that impair the obligations of private contracts. However, this small phrase is not always the easiest to define and decide. Understanding the tests that the Supreme Court uses to determine whether a law runs afoul of the Contract Clause can help you determine if a law may not be proper. However, many laws have been upheld in a subsequent court decision because the state is supporting a legitimate police power through the law.

The Contract Clause holds a massive impact on alternative dispute resolution and many other areas, but the tiny clause often helps protect consumers and citizens in arbitration, mediation, and many other situations.

To learn more about the US contract clause, general dispute resolution, and more, contact ADR Times here!

Emily Holland
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