ContractsProf Blog

Editor: Jeremy Telman
Valparaiso University Law School

Tuesday, January 26, 2021

Farshad Ghodoosi, Contractual Allocation of Risk in Times of Crisis, Part I

Farshad Ghodoosi
Assistant Professor of Business Law
David Nazarian College of Business and Economics
California State University, Northridge

GhodoosiCovid-19 and the resulting pandemic triggered a series of legal and policy questions. A principal legal question in private law has been related to performance of contracts and the scope of force majeure clauses in contracts. The interpretation of contract clauses can sometimes have systemic consequences. For example, if consequences related to Covid-19 are construed to be a “physical loss or damage” under business insurance policies, then we may expect systemic repercussions for insurance companies (more on this here). Similarly, the interpretation of force majeure clauses in contracts and whether Covid-19 falls under “Acts of God” or whether the ensuing shutdowns would be deemed a “governmental act” can have systemic consequences (See e.g., Andrew A. Schwartz recent article here).

In this regard, I had three queries:

In my new paper, which employs various techniques including natural language processing and bootstrapping regression, I try to answer each of the queries above. This post is also divided into three parts based on the inquires stated above.

Today’s post addresses the reasons parties incorporate force majeure clauses in their contracts. I should emphasize at the outset that this area of contract law is riddled with inconsistent decisions and does not always lend itself to easy generalizable theories. This is a work-in-progress and I welcome any comments you may have.

  1. Raison d'etre for Force Majeure Clauses

I pursued this query using law & economics and behavioral economics. Let me give the conclusion (albeit not conclusive nor always generalizable) at the outset. Through force majeure clauses, parties seem to drop the notion of “basic assumption” underlying impossibility & impracticability (and frustration of purpose) doctrines. By doing that, force majeure clauses act as a delegatory clause enabling the courts to look at ex post events and consequences therefrom rather than what parties anticipated/contemplated at the time of contracting (ex ante). Both the Restatement (Second) of Contracts § 265, § 261 and UCC § 2-615 emphasize that the supervening event must be an event the “non-occurrence of which was a basic assumption on which the contract was made.” The most memorable “basic assumption” (albeit in the context of frustration of purpose doctrine to be precise) was the cancellation of the coronation of King Edward VII which was postponed due to the illness of the King. The non-occurrence (or cancellation) of the coronation formed the “basic assumption” of a lease agreement according to the court in Krell v. Henry (1903).

In an empirical analysis of 1,000 force majeure clauses, I found that most parties do not include the phrases related to basic assumptions while they mostly include the word control (see Chart 1 here). The law & economics approach can help us to some extent in this regard (in particular, Ian Ayres & Robert Gertner classic article). The basic assumption requirement in common law provides judicial tailoring of parties’ intent and therefore can act as a “penalty default rule.” This is an incentive to parties to contract around it while eliminating the basic assumption requirement. This makes the contract interpretation less about parties’ intent at the time of formation and more about how the events unfolded after the contract. The behavioral explanation (for example, using Russell Korobkin work here and Ben-Shahar & Pottow here) directs us to analyze these clauses as “sticky” without giving much of a rational explanation as to why parties include these clauses in spite of the same/similar default rule in common law. I conclude that both of these approaches can help us. Seemingly, parties do not desire the courts to look at their intents at the time of contract formation with hindsight bias. This shifts the analysis from “perceived risk” to “actual risk” in contractual interpretation of force majeure clauses. The risk of the basic assumption requirement is that courts may find events “foreseeable” due to the hindsight bias (many believe that pandemics were foreseeable. Didn’t Bill Gates for example warn us about it a long time ago?). This makes Covid-19 not a “black swan” to borrow the parlance of Wall Street. The basic assumption inquiry lends itself to hindsight bias. And it seems that parties would like to avoid it through force majeure clauses.

Tomorrow’s post will discuss the empirical findings regarding the factors that play the most important role in courts’ decisions in force majeure clauses.

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