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When Contract’s Basic Assumptions Fail

Published online by Cambridge University Press:  26 May 2021

Hanoch Dagan  and
Ohad Somech
Hanoch Dagan
Affiliation:
Hanoch Dagan, Stewart and Judy Colton Professor of Legal Theory and Innovation & Director of the Edmond J Safra Center for Ethics, Tel-Aviv University, Israel. [email protected]
Ohad Somech
Affiliation:
Ohad Somech, Post-Doctoral Fellow, Tel-Aviv University, Israel. [email protected]
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Extract

Modern contract law accords considerable significance to the basic assumptions on which a contract is made. It thus takes to heart a failure of a belief whose truthfulness is taken for granted by both parties. Where the failure results from the parties’ mistake at the time of formation, “the contract is voidable by the adversely affected party,” if that mistake “has a material effect on the agreed exchange of performances” and unless that party “bears the risk of the mistake.”1 Where, in turn, the failure of such a basic assumption results from the parties’ erroneous beliefs about future states of the world, a party’s duty to render performance may be discharged if they are not responsible for the supervening impracticability or frustration and “unless the language or the circumstances indicate the contrary.”2

Type
Research Article
Information
Canadian Journal of Law & Jurisprudence , Volume 34 , Issue 2 , August 2021 , pp. 297 - 328
Copyright
© The Author(s), 2021

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Footnotes

Thanks to Oren Bar-Gill, Avihay Dorfman, Victor Goldberg, Tami Kricheli-Katz, Yail Listokin, Jennifer Nadler, and participants of the Israeli Private Law Association 2020 Conference and of the virtual Conference on Global Public-Private Law Approaches to the Covid-19 Pandemic for helpful comments.

References

1. Restatement (Second) of Contracts, (American Law Institute, 1981) §152(1) [Restatement].

2. Ibid at §§261, 265. See also ibid at § 266 (impracticability and frustration).

3. See E Allen Farnsworth, Contracts, 4th ed (Aspen Publishers, 2004) at ch 9.

4. See Sherwood v Walker, 33 NW 919 (Mich Sup Ct 1887) [Sherwood] and Taylor v Caldwell (1863) 122 ER 309 (QB).

5. See, e.g., Krell v Henry, [1903] 2 KB 740 (CA) [Krell] (frustration).

6. The careful language of the text intentionally brackets the question as to whether FBA doctrines originate only in the mid-19th century cases mentioned above or are much older than that. See James Gordley, “Mistake in Contract Formation” (2003) 52:2 Am J Comp L 433 and James Gordley, “Impossibility and Changed and Unforeseen Circumstances” (2004) 52:3 Am J Comp L 513.

7. See Charles Fried, Contract as Promise: A Theory of Contractual Obligations (Harvard University Press, 1981) at 64-67. See also, e.g., Opera Co of Boston, Inc v Wolf Trap Foundation, 817 F (2d) 1094 at 1097-101 (4th Cir 1987).

8. Fried, supra note 7 at 13, 16.

9. Ibid at 59.

10. Ibid at 63.

11. Ibid at 69.

12. Ibid at 73.

13. Cf Mark Gergen, “A Defense of Judicial Reconstruction of Contracts” (1995) 71:1 Ind LJ 45 at 47, 56.

14. See Fried, supra note 7 at 62-63.

15. See the text accompanying note 66.

16. See Farnsworth, supra note 3 at 612.

17. Restatement, supra note 1 at § 154(c). But see Fried, supra note 7 at 69 (presenting the reasonableness inquiry as the test for his sharing principle).

18. See, respectively, Eric Rasmusen & Ian Ayres, “Mutual and Unilateral Mistake in Contract Law” (1993) 22:2 J Legal Stud 309 at 322-23 and Richard A Posner & Andrew M Rosenfeld, “Impossibility and Related Doctrines in Contract Law: An Economic Analysis” (1977) 6:1 J Legal Stud 83 at 90.

19. See, e.g., Robert Cooter & Thomas Ulen, Law and Economics, 6th ed (Pearson, 2012) at 293-94.

20. See Posner & Rosenfeld, supra note 18 at 89.

21. Acquiring information which only affects the distribution of the contractual surplus, rather than its size, is a waste and should therefore be dis-incentivized. The legal rule that achieves this goal depends on the cost of acquiring information: when these costs are low, rescission should be granted for all mistakes of basic assumptions; but if they are high, it should not. By contrast, when the information is beneficial (i.e., productive), the law should incentivize its efficient acquisition. The legal rule that can achieve this goal is also contingent: in most, but not all, circumstances, contract law should not grant rescission of the contract. See Rasmusen & Ayres, supra note 18 at 330-32, 335.

22. See Posner & Rosenfeld, supra note 18 at 90-92.

23. Lon L Fuller & Melvin Aron Eisenberg, Basic Contract Law, 7th ed (West, 2001) at 744.

24. See, e.g., Restatement, supra note 1 at § 152 cmt b.

25. Eric Posner, “Economic Analysis of Contract Law after Three Decades: Success or Failure?” (2003) 112:4 Yale LJ 829 at 846.

26. Ibid at 845.

27. Restatement, supra note 1 at § 154(b). Naturally, “[w]e form contracts in the knowledge that our information is imperfect.” Andrew Kull, “Mistake, Frustration, and the Windfall Principle of Contract Remedies” (1991) 43:1 Hastings LJ 1 at 2. However, the majoritarian default-rule account suggests that the parties are also aware of each of their assumptions, of the probability distribution of their truthfulness, and of the different consequences of their possible failure.

28. See George G Triantis, “Contractual Allocations of Unknown Risks: A Critique of the Doctrine of Commercial Impracticability” (1992) 42:4 UTLJ 450. See also Kull, supra note 27.

29. Cf Transatlantic Financing Corp v United States, 363 F (2d) 312 (DC Cir 1966) [Transatlantic].

30. See Triantis, supra note 28 at 452.

31. Ibid at 474.

32. Ibid at 456.

33. Ibid at 475-76. See also, e.g., Jody S Kraus & Robert E Scott, “Contract Design and the Structure of Contractual Intent” (2009) 84:4 NYU L Rev 1023 at 1074-76.

34. We acknowledge, to be sure, that when legally-informed, sophisticated firms set up a commercial contract, they may often think along the lines of Triantis’ analysis. But the autonomy account—here and elsewhere—nonetheless assumes that general contract law must begin with individuals: the real people which it serves and upon whom it applies its authority and coercive power.

35. See Brian Langille & Arthur Ripstein, “Strictly Speaking: It Went Without Saying” (1996) 2:1 Legal Theory 63 at 80.

36. See Stephen A Smith, Contract Theory (Oxford University Press, 2004) at 280-81.

37. See ibid at 300-01.

38. See, e.g., Curtis Bridgeman, “Reconciling Strict Liability with Corrective Justice in Contract Law” (2007) 75:6 Fordham L Rev 3013 at 3034-39 and John CP Goldberg, “Inexcusable Wrongs” (2015) 103:3 Cal L Rev 467 at 510.

39. See Smith, supra note 36 at 273-74, 299.

40. See, e.g., Smith, supra note 36 at 302.

41. Langille & Ripstein, supra note 35 at 72.

42. See Smith, supra note 36 at 300-01; Langille & Ripstein, supra note 35 at 75-78.

43. Langille and Ripstein recognize this difficulty but radically understate it. See Langille & Ripstein, supra note 35 at 78.

44. See, e.g., Transatlantic, supra note 29 at 315. At times, implied-in-fact FBA theorists try to avoid this difficulty by relying on law itself as part of the public conventions that inform the parties’ basic assumptions. See Langille & Ripstein, supra note 35 at 80. But this direction is circular. It says little about what the content of law can or should be, and therefore—without an independent normative foundation (that these theorists resist)—cannot possibly stand.

45. Peter Benson, Justice in Transactions: A Theory of Contract Law (Harvard University Press, 2019) at 146.

46. Ibid at 152-53.

47. Krell, supra note 5.

48. See Benson, supra note 45 at 152.

49. See the text accompanying note 7.

50. See Jennifer Nadler, “A Theory of Mistaken Assumptions in Contract Law” (2021) 71:1 UTLJ 32 at 59-60.

51. See Hanoch Dagan & Michael Heller, The Choice Theory of Contracts (Cambridge University Press, 2017) and Hanoch Dagan & Michael Heller, “Choice Theory: A Restatement” in Hanoch Dagan, Benjamin Zipursky, eds, Research Handbook on Private Law Theory (Edward Elgar, 2020) 112.

52. See L L Fuller & William R Perdue, Jr, “The Reliance Interest in Contract Damages” (1936) 46:3 Yale LJ 52.

53. Charles Fried, “The Ambitions of Contract as Promise Thirty Years On” in Gregory Klass, George Letsas & Prince Saprai, eds, Philosophical Foundations of Contract Law (Oxford University Press, 2014) 17 at 20.

54. See Farnsworth, supra note 3 at 120-21.

55. Robert E Scott, “A Theory of Self-Enforcing Indefinite Agreements” (2003) 103:7 Colum L Rev 1641 at 1657, 1659.

56. See UCC § 2-204(3) and Restatement, supra note 1 at § 33.

57. See UCC § 2-305.

58. See Michael E Bratman, “Time, Rationality, and Self-Governance” (2012) 22:1 Philosophical Issues 73 at 74.

59. An autonomy-enhancing contract law, that is, takes seriously the voluntary commitments individuals undertake by requiring them to make good on their promises. See the text accompanying note 76.

60. Bratman, supra note 58 at 82.

61. Ibid .

62. As the text clarifies, the concern for the future self does not imply an endorsement of the idea of multiple selves, namely: the disintegration of the self; quite the contrary. Choice theory rejects, rather than subscribes to, this position; indeed, its core claim regarding the significance of planning to self-determination implies that the current self and the future self are the same self. The integrity of the self, rather than its separation to different selves, is what drives choice theory’s justification for contract enforcement, and is thus a necessary feature of its account of the telos of contract. The discussion of the future self is a discussion of the self in the future and the liberal prescription to enable its ability to rewrite its course.

63. Put differently, because there are instances in which a conclusive reason for an alternative exists, for contract law to be autonomy-enhancing, it must take seriously Fried’s insight with which we began, that a promise to perform is not a promise to perform no matter what.

64. A competing explanation of these limitations relies on people’s imperfect foresight. But this explanation is unpersuasive for two reasons. First, as a matter of positive law, the claim that imperfect foresight limits the power to bind is over-inclusive, since it also covers cases of mistaken judgment (such as a bad gamble) that the doctrines at hand do not cover. See the text accompanying note 75. Second, even if this imperfection would be eliminated—say, with proper technology—liberal contract law, properly called, would not authorize indentured servitudes (and the like). See Hanoch Dagan & Michael Heller, “Why Autonomy Must Be Contract’s Ultimate Value” (2019) 20:1 Jerusalem Review of Legal Studies 148 at 150-52.

65. For a detailed defense, both normative and positive, of the role of relational justice in contract law, see Hanoch Dagan & Avihay Dorfman, “Justice for Contracts”, Social Science Research Network (19 June 2020), online at papers.ssrn.com/sol3/papers.cfm?abstract_id=3435781.

66. It is therefore not surprising to see that the requirements for rescission for unilateral mistake are more stringent than those of mutual mistakes, and that they focus on considerations of relational justice. See Restatement, supra note 1 at § 153.

67. This proposition is not dependent upon possible cognitive failures of the employee’s current self or upon possible external effects of the parties’ agreement. See Dagan & Heller, supra note 64 at 150-52.

68. See Stewart E Sterk, “Restraints on Alienation of Human Capital” (1993) 79:2 Va L Rev 383.

69. See Viva R Moffat, “Making Non-Competes Unenforceable” (2012) 54:4 Ariz L Rev 939.

70. To be sure, even in FBA cases one party is ex post satisfied with the contract and wants to enforce it. But the distinction between mutual and unilateral mistake implies that in the former category the contract does not in fact embody the (ex ante) plan of either party. In other words, the party who seeks enforcement in an FBA case tries, in a sense, opportunistically to rely on the FBA in order to get from the deal more than the joint plan contemplated. This is exactly why, unlike cases of unilateral mistakes, in FBA cases rescission need not rely on concerns of relational justice. The party seeking rescission in these cases is not invoking the other party’s obligation to respect their self-determination; rather, they are simply defending against the other’s attempt to overreach.

71. Restatement, supra note 1 at § 152 cmt b.

72. Restatement, supra note 1 at § 261 cmt b.

73. Ibid.

74. A critic may wonder whether these cases are actually not so easy in the sense that they may be accounted for even with no reliance on an autonomy-based theory of contract. Any view that insists on the familiar tort law maxim in which civil liability requires effective agency can, so the argument goes, account for FBA doctrines. But this critique misses the mark, because it fails to appreciate the significance of the distinction between contracts and torts. Contracts are voluntary obligations and thus oftentimes contractual liability attaches even though the cause for nonperformance was well beyond the promisor’s control. See, e.g., Stees v Leonard, 20 Minn 494 (Sup Ct 1874). Indeed, part of the implication of contract’s autonomy-enhancing function is that it does not delimit the power to commit along these lines.

75. Miscalculation is oftentimes the result of a mistaken judgment, while misprediction derives from either inadvertence or no judgment at all.

76. On the significance of regret to human decision making, see, e.g., Terry Connolly & Jochen Reb, “Regret Aversion in Reason-Based Choice” (2011) 73:1 Theory & Decision 35 and Marcel Zeelenberg & Rick Pieters, “A Theory of Regret Regulation 1.0” (2007) 17:1 Journal of Consumer Psychology 3. On the interrelation between regret and choice theory, see Ohad Somech, “The Uneasy Move from Autonomy to Alternatives: Self-determination, Regret, and the Process of Autonomous Choice” (2019) 20:1 Jerusalem Review of Legal Studies 133.

77. See Seana Valentine Shiffrin, “Paternalism, Unconscionability Doctrine, and Accommodation” (2000) 29:3 Philosophy & Public Affairs 205 at 207, 213, 215, 220, 231.

78. Empirical evidence suggests that in these types of circumstances an inability to rewrite one’s life story could lead to an abandonment of the overall project for which the contract was formed, thus further hindering one’s self-determination. See Sunghwan Yi & Hans Baumgartner, “Coping with Negative Emotions in Purchase-Related Situations” (2004) 14:3 Journal of Consumer Psychology 303 at 313-314; Marcel Zeelenberg et al, “On Bad Decisions and Disconfirmed Expectancies: The Psychology of Regret and Disappointment” (2000) 14:4 Cognition & Emotion 521 at 528; Marcel Zeelenberg et al, “The Experience of Regret and Disappointment” (1998) 12:2 Cognition & Emotion 221 at 228.

79. See Dagan & Dorfman, supra note 65 at 48-52.

80. Jacob & Youngs, Inc v Kent, 129 NE 889 at 891 (NY Ct App 1921).

81. See Part III-A s 2, above.

82. See UCC § 2-204(3).

83. See UCC § 2-306.

84. Brown v Cara, 420 F (3d) 148 at 153 (2nd Cir 2005), citing Teachers Ins & Annuity Ass’n v Tribune Co, 670 F Supp 491 at 498 (SD NY 1987).

85. Ibid.

86. The cautionary language of the text derives from the less-than-ideal performance of this rule’s autonomy-enhancing task.

87. See, e.g., Lenawee County Bd of Health v Messerly, 331 NW (2d) 203 at 209 (Mich Sup Ct 1982) [Lenawee County].

88. Sherwood, supra note 4 at 923.

89. Sherwood, supra note 4 at 924.

90. Ibid .

91. Ibid .

92. Ibid . The dissent interpreted the facts differently, conceiving the case as one of unilateral mistake. Unilateral mistakes, however, should be (and are) analyzed differently. See the text accompanying note 66.

93. See, e.g., Lenawee County, supra note 87 at 207; Mishara Constr Co v Transit-Mixed Concrete Corp, 310 NE (2d) 363 at 367 (Mass Sup Jud Ct 1974); Orlandi v Goodell, 760 F (2d) 78 at 79 (4th Cir 1985).

94. See Florida Power & Light v Westinghouse Elec, 826 F (2d) 239 at 245-246, 269, 271 (4th Cir 1987) (cert denied, 485 US 1021 (1988)).

95. For another example that illustrates some subtleties in this conventionalist inquiry, consider agreements for the manufacturing of industrial equipment and machinery. The coronavirus crisis may have adversely affected both parties to such agreement, but their FBA-related significance varies. Thus, decrease in demand may render buying new industrial equipment a losing proposition, and buyers whose contracts lost part of their value may seek relief on FBA grounds. But this change in value per se is not an FBA, since the value of the equipment to the specific buyer is not an assumption shared by the parties. Only if the equipment sold was to be used for the production of goods or products that the crisis has rendered no longer socially acceptable would this amount to an FBA. It seems, however, hard to think of an example that can fit this description, which may suggest that buyers would rarely, if ever, succeed in their FBA claims.

Manufacturers’ possible FBA claims, in turn, are more complicated and mostly depend on the measures taken to contain the virus. Thus, on one end of the spectrum, where no limitation on manufacturing activity has been placed, no FBA has occurred. At the other pole, where a state prohibits the manufacturer’s activity, a shared basic assumption has indeed failed: with no contrary indications, when the parties’ joint project concerns the manufacturing of a specific equipment, both parties can be said to have taken for granted that its production can be lawfully pursued. Other cases are not clear-cut, since the measures taken by states may fall in between these two poles.

Consider two intermediate examples: in one, manufacturing is allowed but only in a limited capacity; in the other, manufacturers may function in any capacity they desire, but must meet certain (possible but costly) conditions. In the first example, where the maximum legal capacity does not allow a manufacturer to meet its contractual obligations, we are close to the FBA end of the spectrum. That is, the restriction makes illegal (part of) the activity required to fulfil the contractual obligation and therefore a shared basic assumption has failed. By contrast, a state’s imposed conditions that make production costlier is closer to the other end of the spectrum: while the conditions may cause the contract to be a losing project for the manufacturer, parties do not share assumptions about each other’s profitability.

96. See David A Hoffman & Cathy Hwang, “The Social Cost of Contract” Colum L Rev [forthcoming in 2021].

97. See, e.g., Lynn M Clark, “Landlord Attitudes Toward Renting to Released Offenders” (2007) 71:1 Federal Probation at 20.

98. See In re Hitz Restaurant Group, No 20 B 05012 (Bankr ND Ill 2020) at *6 [In re Hitz].

99. See Restatement, supra note 1 at §§ 154 (a) & (b), 161.

100. See respectively, e.g., Lenawee County, supra note 87 at 205, 210-11 and Northern Indiana Public Service Co v Carbon County Coal Co, 799 F (2d) 265 (7th Cir 1986) [Northern Indiana].

101. A settlement may still be rescinded on other grounds.

102. Wieland v Cedar Rapids IC Ry Co, 46 NW (2d) 916 at 919 (Iowa Sup Ct 1951). See also, e.g., Fisher Development Co v Boise Cascade Corp, 37 F (3d) 104 (3rd Cir 1994) and Billhartz v CIR, 794 F (3d) 794 at 799 (7th Cir 2015).

103. See, e.g., Wood v Boynton, 25 NW 42 (Wis Sup Ct 1885).

104. See, e.g., BP Group, Inc v Kloeber, 664 F (3d) 1235 at 1241 (8th Cir 2012).

105. Aluminum Co of Am v Essex Group, 499 F Supp 53 at 56, 59, 68, 70 (WD Pa 1980) [Alcoa].

106. See, e.g., Jody P Kraus & Robert E Scott, “The Case Against Equity in American Contract Law” (2020) 93:6 S Cal L Rev 1323 at 1377-80 and Robert A Hillman, “Maybe Dick Speidel Was Right About Court Adjustment” (2009) 46:3 San Diego L Rev 595 at 598-603.

107. See Christopher C French, “COVID-19 Business Interruption Insurance Losses: The Cases For and Against Coverage” (2020) 27:1 Conn Ins LJ 1.

108. See, e.g., Ner Tamid Congregation of North Town v Krivoruchko, 638 F Supp (2d) 913 at 929 (ND Ill 2009); Tri-Town Const Co v Commerce Park Assocs 12, LLC, 139 A (3d) 467 at 475 (RI Sup Ct 2016); Great Lakes Gas Transmission Ltd P’ship v Essar Steel Minnesota, LLC, 2013 WL 12139846 at *12-14 (DMinn Mar 19, 2013), vacated on other grounds, 843 F (3d) 325 (8th Cir 2016); Vision Bank v Luke, 2010 WL 2639626 at *2 (ND Fla June 29, 2010). For similar holdings in other contexts, see, e.g., Sheng v Starkey Laboratories, Inc, 117 F (3d) 1081 at 1084 (8th Cir 1997) and SCI Minnesota Funeral Services v Washburn-McReavy Funeral, 795 NW (2d) 855 at 862 (Minn Sup Ct 2011).

109. Dover Pool & Racquet Club v Brooking, 322 NE (2d) 168 at 169-71 (Mass Sup Jud Ct 1975). See also Jeselsohn v Park Trust Co, 135 NE 315 (Mass Sup Jud Ct 1922); Monet v PERA, 877 SW (2d) 352 at 357 (Tex Ct App 1994); Knudsen v Jensen, 521 NW (2d) 415 at 418-419 (SD Sup Ct 1994).

110. Groseth Int’l v Tenneco, 410 NW (2d) 159 at 163, 166-67 (SD Sup Ct 1987) [Groseth]. See also Eastern Air Lines, Inc v McDonnell Douglas Corp, 532 F (2d) 957 at 991 (5th Cir 1976).

111. See The Coronavirus Aid, Relief, and Economic Security (CARES) Act, 116th Cong, 2020 (HR 748).

112. See Restatement, supra note 1 at § 154(c). Some courts, notably the Indiana courts, dissent. See Wilkin v 1st Source Bank, 548 NE (2d) 170 (Ind Ct App 1990).

113. See Karl Wendt Farm Equipment v International Harvester, 931 F (2d) 1112 at 1120 (6th Cir 1991); Groseth, supra note 110 at 166; US v General Douglas MacArthur Senior Village, Inc, 508 F (2d) 377 at 381 (2nd Cir 1974).

114. See PK Development v Elvem Development, 226 AD (2d) 200 at 201-02 (NY Ct App 1996) and Wasser & Winters v Ritchie Bros Auctioneers (America), 185 P (3d) 73 at 76-80 (Alaska Sup Ct 2008). See also Aldrich v Travelers Ins Co, 56 NE (2d) 888 (Mass Sup Jud Ct 1944) and Nelson v Rice, 12 P (3d) 238 at 242 (Ariz Ct App 2000). A similar rule applies when courts reform (as opposed to rescind) contracts for mutual mistake. See Roseburg Lumber Co v Madigan, 978 F (2d) 660 at 668-69 (Fed Cir 1992) and Flippin Materials Co v United States, 312 F (2d) 408 (Ct Cl 1963).

115. See Restatement, supra note 1 at §§ 269-270 and Alcoa, supra note 105 at 78-80. For the application of intermediary remedies in the current crisis, see In re Hitz, supra note 98 at *7.

116. When applying the FBA doctrines, courts often discuss their equitable roots. See, e.g., Lloyd v Murphy, P (2d) 47 at 50 (Cal Sup Ct 1944). In this context, if not in others, equity should be understood in terms of relational justice. Cf Hanoch Dagan & Avihay Dorfman “Substantive Remedies” (2020), 96:2 Notre Dame L Rev 513.

117. See Krell, supra note 5.

118. See Northern Indiana, supra note 100 at 277. Compare Victor P Goldberg, “Excuse Doctrine: The Eisenberg Uncertainty Principle” (2010) 2:1 Journal of Legal Analysis 359 at 362-66.

119. See also Restatement, supra note 1 at § 152 cmt c and Vrabel v Scholler, 85 A (2d) 858 at 860 (Pa Sup Ct 1952).

120. See Restatement, supra note 1 at §263, Ill 2 & 7 and UCC 2-615 cmt 9.

121. See Eastern Air Lines, Inc v Gulf Oil Corp, 415 F Supp 429 (SD Fla 1975); Carolinas Cotton Growers Ass’n, Inc v Arnette, 371 F Supp 65 (DSC 1974); Northern Indiana, supra note 100 at 277; Transatlantic, supra note 29. But see Alcoa, supra note 105.

122. See generally Goldberg, supra note 118 at 375; Gergen, supra note 13 at 55-56. A similar analysis explains and justifies Shell Oil v Estate of Kert, 411 NW (2d) 770 (Mich Ct App 1987).