Contracts and Crises

The tussle over AIG bonuses brings back a familiar crisis meme: the sanctity of contracts.  It is a red herring – sort of.

Any financial collapse worth its salt runs into contracts that might have been a good idea in good times, but now look disastrous because they threaten either widespread economic distress (mortgage and securitization contracts), or gross political embarrassment (bonus commitments).  Every government fighting a crisis thus faces a choice whether to enforce such contracts.  Enforcing contracts where private parties have no money means either suffering default and firm failure, or using public funds to pay up on the parties’ behalf.  The alternative is using government power to rewrite the contracts.

There is no doubt that the U.S. Congress has such power aplenty.  In an article coming out in the Southern California Law Review, Adam Levitin and I examine Supreme Court jurisprudence assessing the veritable extravaganza of contract rewriting in the New Deal.  In opinions spanning over two decades, the Court was unequivocal:  the government’s power to regulate the economy, not just to manage economic emergency, trumps private contracts.  In an opinion stripping payment-in-gold clauses from private debt obligations, the court observed colorfully:

There is no constitutional ground for denying to the Congress the power expressly to prohibit and invalidate contracts although previously made, and valid when made, when they interfere with the carrying out of the policy it is free to adopt. … To subordinate the exercise of the Federal authority to the continuing operating of previous contracts would be to place to this extent the regulation of interstate commerce in the hands of private individuals and to withdraw from the control of the Congress so much of the field as they might choose by “prophetic discernment” to bring within the range of their agreements. (Norman v. Baltimore & Ohio R.R. Co., 294 U.S. 240 (1935)).

Moreover, while the Constitution constrains states from freely mucking with private contracts, Supreme Court jurisprudence gives them considerable power to suspend enforcement to address economic emergency.  (Home Building & Loan Ass’n v. Blaisdell, 290 U.S. 398 (1934) (suspending foreclosures in Minnesota)).

Adam and I are not the first to exhume these cases.  Randy Kroszner’s study of the market reaction to the Gold Clause Cases has been cited for years in connection with emerging markets governments’ dalliance with abrogation.

Smart policy makers now invoking the sanctity meme know this.  So are they being cynical, or does sanctity mean something other than legal immutability?  I think the latter.

Although rewriting contracts by federal law is relatively easy, it is not a bullet you can use willy-nilly over and over.  For contracts to be worth more than the disk space they take up, they must be enforced for the most part most of the time.  If financial meltdowns are to become more frequent and more severe, are we committing to rewrite contracts every decade?  If not, what qualifies as a good enough reason for the government to deploy its red pen – is moral outrage and political embarrassment enough, or should it be saved for cases that get more economic bang for the buck?  After all, the gold clause move made it possible for the United States to get off the gold standard, and pre-empted something like a 70% jump in the national debt stock in 1933.

I suspect it is considerations like these, not romantic notions of contracts, that drove the Administration talking points on last Sunday’s talk shows.

Does the President disagree?  I am not sure.  Exploring “every single legal avenue” does not mean doing as you please.  For starters, you need legislation.  Not even FDR rewrote contracts on his own.  Second, even the wildly broad language of the Gold Clause Cases and their progeny requires that the offending contracts “interfere” with government policy.  Do AIG bonuses interfere with TARP?  Perhaps, but it would be nice to know how and how much.

Put differently, this crisis has seen no shortage of insanely outrageous behavior, inanely justified (think retention imperative).

Even so, at least to this Contracts teacher, outrage is not enough to bring on the big guns.  Of course the government can still shame, interpret, tax and sue to get the money back — all short of rewriting the contracts — and it might leverage the outrage to get real relief where it matters.

Where contracts turn into social suicide pacts, the cost of abrogation seems small by comparison.  But abrogating early and often risks wasting a good tool.


My paper with Adam Levitin:

My solo paper arguing that contract abrogation is a crisis fixture: Kroszner Gold Paper Summary: [note the link at the end has stopped working for me]

My Home Page:

Adam’s Home Page:

2 Responses to "Contracts and Crises"

  1. Anonymous   March 20, 2009 at 12:21 pm

    There’s a reason people hate lawyers. Their fanciful wordplay can’t disguise afoundation rule by fiat. Hitler was very good at making his actions “legal”.This is an abomination. If Congress was so disgusted by the misuse of bailout funds, they should return the money they and their PAC’s received in the 2008 elections.You are a tool.

  2. Waubay   March 25, 2009 at 3:11 pm

    How about the issue of CDS contracts creating firms that are ‘too big to fail’? CDS contracts that will not allow a firm to go bankrupt without crashing the entire financial system. I think it is time to pull out the ‘big guns’ and abrogate all CDS contracts thus allowing insolvent firms to go into bankruptcy and giving a mechanism to flush the bad debt from the system.