Virtual Symposium Part IX: Hanoch Dagan and Ohad Somech Part I, Failures of Basic Assumptions

When Contract’s Basic Assumptions Fail: From Rose 2d to COVID-19

Hanoch Dagan & Ohad Somech

When we started this project, in May 2019, we set out to develop a liberal account of three contract law doctrines: mutual mistake, frustration, and impracticability. These three doctrines tackle a fundamental problem in contracts: the failure of a basic assumption shared by the parties (or, FBA as we call it). At that time, the FBA doctrines were of theoretical importance, but of little practical use. This is no longer the case. As prior contributions to this Symposium point out (Stephen Wilks; Andrew Schwartz; and Mitu Gulati and Mark Weidemaier), frustration and impracticability are expected to feature heavily in Coronavirus litigation. We thus take the crisis – that is: both the virus and the measures to contain it – as a case study for our FBA theory.

A Liberal Account of the FBA Doctrines – Part I: What Makes an Assumption Basic? Does the Pandemic Constitute an FBA?

We begin with first principles. Contract is an empowering practice that is, and should be, guided by an autonomy-enhancing mission. Contract’s operative doctrines allow people legitimately to recruit others to their projects by committing their own future selves in return, thus advancing a joint plan. This commitment necessarily curtails the self-determination of the parties’ future selves. Therefore, liberal contract law must ensure that by advancing the autonomy of the parties at the time of formation it does not overly compromise the autonomy of their future selves. This maxim is the key to understanding the FBA doctrines.

These doctrines allow a party to withdraw from the contract if: (i) a shared basic assumption failed; (ii) the party seeking excuse did not assume the risk; (iii) the failure had a material effect on the exchanged considerations; and (iv) the court does not find it reasonable to allocate the risk to the party seeking to withdraw. These elements help address the two questions the FBA doctrines invoke: (1) what makes an assumption basic; and, (2) when an FBA occurs, what are its legal consequences? In this Part of our contribution we focus on the first question. We will turn to the second question in Part II.

A focus on the autonomy of the parties’ future selves implies that an assumption is basic if its failure undermines the agreement’s autonomy-enhancing properties. This means that a basic assumption is one which pertains to the essence of the parties’ agreement – the raison d’être of their joint plan.

Divining the essence of an agreement does not call for a metaphysical inquiry (the pertinent question in Sherwood v. Walker is not “what is the essence of a cow?”). As with other doctrinal contexts, an autonomy-enhancing contract law takes an objective approach, which relies on prevailing conventions. It examines the type of contract at hand, and more particularly the way actors in the relevant market typically understand the main purpose of this contract type. A careful reading of courts’ decisions (e.g., Florida Power & Light v. Westinghouse, Lewanee Bd. of Health v. Messerly, and Dingeman v. Reffitt) confirms that this is, in fact, what they actually do.

What does this finding mean for COVID-19 related litigation? Most parties to contracts formed before the virus began to spread did not consider the possibility of a global and lasting pandemic or the measures countries have taken (and are still taking) to contain it. Does this imply that the parties’ presupposition as per the absence of a pandemic is tantamount to a basic assumption? The answer varies, as we’ve just noted, across contract types.

Take, for example, rental agreements and focus first on residential ones. Renters, especially if they lost their job because of the crisis, may seek to be excused from the obligation to pay rent based on an FBA. We think that people experiencing economic upheaval due to the crisis should be certainly aided by the State; and we do not necessarily rule out the possibility that other contractual doctrines may be applicable (on this subject, see Cathy Hwang and David Hoffman’s recent work). But we think that the FBA doctrines are not.

The reason is twofold. First, renters and landlords rarely share assumptions about renters’ financial abilities. Instead, they usually acknowledge the uncertainty and allocate the risk. Second, and more importantly, COVID-19 simply did not trigger an FBA in this type of contract. The joint project in residential rents is housing for money, and the virus did not change people’s need for a place to live or their ability to use the property for that purpose. COVID-19, that is, did not undermine the essence of residential rent agreements.

Commercial rents – for example, of a restaurant – are different. To be sure, like in residential rents, parties to commercial rents do not usually share assumptions about the renter’s financial ability or profits. But they do share the assumption – namely: they take for granted – that eating at restaurants is a socially acceptable behavior. When this stops being the case – for example, due to an imposed lockdown or because the virus caused our social habits to change – COVID-19 is deemed to have caused an FBA.

Another example can further highlight the factual aspect of the inquiry. Consider agreements between students and their colleges or universities. We understand the essence of this contract type to be tuition for education. If this is indeed how most parties understand it and if online teaching can (roughly) accomplish this goal, then COVID-19 did not undermine its essence. It has, however, been quite a while since either of us was a student and we may be wrong about the facts. If most relevant actors – that is, students and universities – consider the cultural and social parts crucial aspects, which are part of the essence of their agreement, then COVID-19 may have indeed caused an FBA.

Thus far, we asked whether COVID-19 undermined a basic assumption. But it is also important to examine whether what was undermined was indeed an assumption. Going into a contract, the parties hold various beliefs; but not all beliefs are shared assumptions. An assumption is something taken for granted by the parties – not something that they contemplated, were aware of its uncertainty, and explicitly or implicitly allocated its risk. When the parties are aware that something is uncertain, then, proceeding with the agreement implies that they made the choice to bind their future selves despite the risk. Enhancing their autonomy in this case requires to respect their choice.

Here too a conventionalist approach is in order. That is, to understand what risks the parties have implicitly allocated, we need to consider the risks that are salient to actors in the relevant market. One way to perform this task is to examine the insurance policies market actors typically procure and inquire which types of risks are covered and especially which risks that not covered are nonetheless made salient.

Take again the restaurant example. Commercial renters typically procure “business interruption insurance” that covers renters’ lost profits. Does this indicate that the parties were aware of the relevant risk? As it turns out, business interruption insurance pertains mostly to lost revenue due to physical damage to the property. If this is indeed the case (see Christopher French’s work), then it is only this type of risk – and not lost profits due to the coronavirus crisis – that is made salient by the policy, and that, whether actually covered or not, can be assumed to have been allocated by the parties.

Finding that an FBA had occurred brings us half way through the analysis. We discuss the second half – the legal consequences of an FBA – in Part II.