Proposed COVID-19 Legislation Thrusts Contract Clause’s Original Purpose Into Spotlight

Until fairly recently, the U.S. Constitution’s Contract Clause had fallen into relative obscurity.  Proposed legislation concerning insurance coverage for the COVID-19 pandemic figures to place this provision of the U.S. Constitution squarely before the courts once again.

The Contract Clause prohibits the States from enacting any “[l]aw impairing the Obligation of Contracts.”¹  Although not obvious from the Constitutional Convention debates, the prevailing belief is that the Contract Clause was designed to limit the States from enacting retroactive debtor-relief laws.²  Under the Articles of Confederation, the States passed retroactive debtor-relief laws to address pervasive economic depression following the American Revolution.³  Such laws, however, also destabilized contractual relations and caused creditors to withdraw from capital markets for fear of new laws later re-writing debt contracts.⁴  Indeed, James Madison wrote in The Federalist No. 44 that “some thorough reform is wanting which will banish speculations on public measures, inspire a general prudence and industry, and give a regular course to the business of society.”⁵  Accordingly, the Contract Clause limits a legislature’s ability to favor and redistribute wealth to select groups by retroactively rearranging obligations in private contracts.⁶

Until the late nineteenth century, the U.S. Supreme Court regularly invoked the Contract Clause to void legislation by the States that would retroactively rearrange the contractual rights between parties.⁷  But by the end of the nineteenth century, courts largely ignored the Contract Clause as they began evaluating laws under more liberal substantive due process legal analyses.⁸  In the 1970s, the U.S. Supreme Court revitalized the Contact Clause with a substantive due process sheen.⁹  As the U.S. Supreme Court reaffirmed in Allied Structural Steel Co. v. Spannaus, the Contract Clause “is not, however, the Draconian provision that its words might seem to imply.  As the Court has recognized, ‘literalism in the construction of the contract clause … would make it destructive of the public interest by depriving the State of its prerogative of self-protection.’”¹⁰  The U.S. Supreme Court has since applied a two-step test for evaluating whether a law violates the Contract Clause: (1) whether the law “operated as a substantial impairment of a contractual relationship”, and (2) whether the law is drawn in an “appropriate” and “reasonable” way to advance “a significant and legitimate public purpose.”¹¹

In the context of the insurance industry, there has been a recent resurgence of courts applying the Contract Clause to void laws that shifted economic burdens by retroactively undermining the benefit of the bargain in insurance policies.  In Society Insurance v. Labor & Industry Review Commission, the Supreme Court of Wisconsin held that two laws eliminating a twelve-year statute of limitations for providing worker’s compensation benefits for traumatic injury claims violated the Contract Clause when retroactively applied to insurance policies.¹²  The Supreme Court of Wisconsin held that eliminating the statute of limitations to maintain the solvency of Wisconsin’s work injury supplemental fund was not a significant and legitimate public purpose justifying a “significant financial burden being shifted to insurers.”¹³

In Harleysville Mutual Insurance Co. v. State, the Supreme Court of South Carolina held that a state law defining “occurrence” to expand coverage for faulty workmanship violated the Contract Clause when retroactively applied to insurance policies.¹⁴  Two years later, the Supreme Court of South Carolina similarly held that a state law defining “actual charges” violated the Contract Clause when retroactively applied.¹⁵  In Kirven v. Central States Health & Life Co., the Supreme Court of South Carolina held that altering the meaning of “actual charges” to increase the “affordability of specified disease policies” did not support a legitimate public purpose.¹⁶

The COVID-19 pandemic has prompted some States to propose legislation affecting existing insurance policies.  For instance, New York introduced Assembly Bill 10226 requiring that the COVID-19 pandemic be a “covered peril” for commercial property policies so as to provide coverage for business interruption.¹⁷  Louisiana¹⁸, Massachusetts¹⁹, New Jersey²⁰, Ohio²¹, Pennsylvania²² and South Carolina²³ are among the States that have similar legislation pending.  Such legislation is designed to shift the economic burden of the COVID-19 pandemic from certain entities in the economy (such as small businesses) to insurance companies by rearranging the obligations in existing insurance policies.

If the States enact legislation requiring existing insurance policies to provide COVID-19 coverage on a retroactive basis, such legislation would likely face a constitutional challenge under the Contract Clause.  In Western National Mutual Insurance Co. v. Lennes (In re Workers' Compensation Refund), the U.S. Eighth Circuit Court of Appeals held that the Minnesota legislature could not retroactively redistribute $400 million in excess reinsurance premiums to employers within the state, in violation of the “reasonable contractual rights” of insurers who had paid the premiums.²⁴  The Eighth Circuit observed that heavy state regulation of an industry “does not automatically foreclose the possibility of contract impairment.”²⁵  And, apropos to pending COVID-19 legislation, the Eighth Circuit further noted that “[l]egislative perception regarding the more worthy recipient [of an economic benefit] does not render a complete divestiture of contractual rights a legitimate state interest.”²⁶ 

Given the fact- and policy-specific inquires required by a Contract Clause analysis, how courts apply the Contract Clause’s prohibitions to proposed COVID-19 legislation will require a careful balancing of the defined societal benefits against the expected integrity of affected contracts.  Consequently, challenges to COVID-19 legislation that retroactively alter the terms of insurance policies to shift the economic burden of the pandemic will likely invoke arguments reminiscent of those serving as the original basis for the Contract Clause.