ContractsProf Blog

Editor: Jeremy Telman
Valparaiso University Law School

Thursday, September 24, 2020

Virtual Symposium Part IX: Ohad Somech and Hanoch Dagan, Part II: What Follows When Basic Assumptions Fail

A Liberal Account of the Failure of a Basic Assumption (FBA) Doctrines – Part II: What Follows an FBA?
Hanoch Dagan & Ohad Somech

Part I of our contribution offered a liberal perspective of the FBA doctrines. We claimed that the main mission of these doctrines is to safeguard the autonomy of the parties’ future selves.  We now turn to FBAs’ legal consequences.

SomechThe first step here is (surprisingly) straightforward. To see why, compare an FBA to cases of a unilateral mistake, where the basic assumption of only one party failed. In those cases, contract law needs to balance competing autonomy claims: the agreement turns out to be incompatible with the mistaken party’s; but the other party can credibly argue that “this is the contact I bargained for and respecting my autonomy requires its enforcement.”

FBA cases are critically different because they involve failure of assumptions shared and take for granted by both parties – not a miscalculation or a losing bet by one of them. Of course, in hindsight, one of the parties may be pleased with how things turned out. But the fact is that both parties made the same false assumption, and so neither can now credibly claim that the script enshrined in the agreement corresponds to her ex ante plan.

When the essence of an agreement fails, its enforcement no longer serves the contracting parties’ original joint plan. In such cases, curtailing the autonomy of the future self cannot be justified by reference to contract’s autonomy-enhancing function.  This means, at least for liberal contract law, that it cannot be justified, period.

COVIDHow, then, should contract law proceed and what are the legal implications (if any) of the parties’ failed attempt to form a contract and of the script they have created? The first answer to this question follows another core principle of liberal contracts: active facilitation. As shown a previous article, in complying with its autonomy-enhancing task, contract law goes out of its way in proactively facilitating peoples’ attempts to use contract for advancing their joint projects. Applied to the FBA doctrines, this means that if the FBA did not materially affect their joint project, contract law should reinstate the script the parties created notwithstanding its failure.

This conclusion may again be relevant to the COVID-19 litigation. Often, when COVID-19 undermined a basic assumption of the parties, it also generated a material effect on the exchanged considerations. But this is true only where the effects of the crisis were left unmitigated and may not be the case otherwise. Both the Federal government and States have taken measures to mitigate the effects of COVID-19 and some of these measures change the analysis.  

One example is the Federal Paycheck Protection Program that provides government assistance to businesses to cover their operating costs. The Program is pertinent here not because the government provides people with funds. As we explained in Part I, financial ability per se rarely factors in the analysis because parties seldom share assumptions about it. Instead, what is crucial is whether state funds are made available for the purpose of allowing the contractual relations to continue. Thus, if a business receives money in order to pay its operating costs, it can no longer argue that COVID-19 had a material effect on its rent agreement. Or, to give another example, a factory that had to temporarily close because of a lockdown but received funds for payroll purposes cannot resort to the FBA doctrines to terminate employment contracts.

Hanoch DaganThe flipside, as already hinted, is that government assistance does not always mean that the effect of COVID-19 is no longer material. One example is car insurance. Parties to such agreements do not share assumptions about the insured’s use of the car. But, like with the restaurant example, they both assume that driving is a socially acceptable behavior. When this stops to be the case, as when a lockdown is imposed, an FBA has occurred, and its effect – leaving the insured party with no benefits – is material. This remains true even if the insured receives government assistance (e.g., unemployment pay). Because neither eligibility nor the program’s purpose hinges on maintaining these insurance contracts, such payments do not affect an insured’s FBA claim.

Once this first bridge is crossed and the effect of COVID-19 on the exchanged considerations is deemed material, there is little left from the parties’ agreement to save, and the question becomes one of risk allocation. At this point, an autonomy-enhancing contract law should allocate that risk in a way that can best vindicate the parties’ reasonable expectations. This calls for a majoritarian risk allocation which arguably conforms to the parties’ ex-ante beliefs and best reflects their (hypothetical) choice of how to advance their joint project.

In many cases, a majoritarian allocation would require the performance of the script the parties have created or, conversely, excusing performance in its entirety. But in some cases, an intermediary solution is required.

Consider the restaurant example one last time. Renters often invest a lot of money in renovating and adjusting the property to their specific needs and desires. Simply allowing them to terminate the agreement and walk away from the restaurant will be unhelpful and indeed frustrate, rather than advance, their expectations. Existing doctrine offers a better solution: temporarily excusing or reforming renters’ duty to pay rent. On this subject, we recommend Jonathan Lipson’s work on the subject of standstill agreements and his contribution to this symposium. This rule nicely guides courts to craft a ruling that recognizes that the loss at hand is due to a failure of a shared assumption that undermined the parties’ joint project, which the parties did not contemplate.

It goes without saying that COVID-19 is one of the most momentous events of our lifetimes. Such an event requires a public commitment to aid those harmed by it, be it psychically, economically, or mentally. However, contract law in general and the FBA doctrines in particular are not (and should not) always be up to this task. It is therefore not surprising that, following our analysis, the FBA doctrines are not applicable in all cases in which the party seeking to be excused suffered from one or more of COVID-19’s detrimental effects.

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