The U.S. Supreme Court and the Contract Clause Today: Implications for Public Pension Reform

The Contract Clause (“No State shall . . . pass any . . . Law impairing the Obligation of Contracts”) is one of the lesser-known guarantees in the U.S. Constitution. But you wouldn’t have found it obscure if you were practicing law before the Civil War. Back then, when the Constitution imposed few constraints on state governments, the Contract Clause was the most litigated part of the whole Constitution. Early in his career, Daniel Webster was well known for having litigated the famous Contract Clause case of Dartmouth College v. Woodward (1819) before the Supreme Court.

Today, you’re likely to be intimately familiar with the Contract Clause (and its analogs in state constitutions) if you follow the law of public-employee pensions because it’s a popular argument for public employee unions seeking to challenge state-level pension reforms.

The Contract Clause has fallen and risen since Daniel Webster’s day. Starting in the 1870s, courts began to hold that states had an inalienable “police power”—the power to protect public health, safety, and morals—that couldn’t be bargained away by contract. Accordingly, when a state passed a law abridging contractual rights and claimed a police power justification, courts would routinely defer to the legislative judgment.

In 1921, the Supreme Court held—with Justice Oliver Wendell Holmes, Jr., writing the opinion—that World War I-era municipal rent-control ordinances (which abridged existing leases) were justified by the wartime emergency; and in 1934, Chief Justice Charles Evans Hughes wrote a similar opinion—invoking the emergency conditions of the Great Depression—upholding a Minnesota law imposing a moratorium on foreclosure of delinquent mortgages.

By the 1940s, the Supreme Court had virtually read the Contract Clause out of the Constitution, applying a balancing test that granted almost complete deference to state legislatures. This coincides with the court’s abandonment of most other constitutional restraints on regulation in various other areas, from the Non-Delegation Doctrine to the Commerce Clause to (at least as far as economic regulation was concerned) the Due Process Clause.

It took until the late 1970s for the Supreme Court to renew its interest in the Contract Clause, and even then, it merely adopted a new balancing test that was somewhat less deferential to state governments. In U.S. Trust Co. of New York v. New Jersey (1977), Port Authority bondholders sued New York and New Jersey under the Contract Clause. They had bought bonds in the 1960s, relying on the states’ statutory promise not to use certain revenues and reserves to subsidize rail passenger transportation as long as the bonds remained unpaid. Then, in 1974, both states retroactively repealed that guarantee.

The Supreme Court sided with the disgruntled bondholders, holding that the repeal of the guarantee was neither necessary nor reasonable. While courts should “properly defer to legislative judgment as to the necessity and reasonableness of a particular measure,” such “complete deference . . . is not appropriate” when “the State’s self-interest is at stake,” i.e., when a state seeks to abrogate its own contracts.

According to the majority opinion, “a State cannot refuse to meet its legitimate financial obligations simply because it would prefer to spend the money to promote the public good rather than the private welfare of its creditors.”

The revival of the Contract Clause had obvious implications for state-level pension reform. In the early days when the Contract Clause was strong—and even well into the 20th century—public-employee pensions (generally defined by statute and not by explicit contracts) were usually considered gratuities, which the state could abrogate at will. But by the 1970s, states were increasingly coming to recognize that pensions, as forms of deferred compensation, should be understood as implicit contractual obligations.

California’s use of the Contract Clause dates back to the 1950s—though often it wasn’t clear whether California courts, when they were protecting pensions against legislative modification, were relying on the federal clause or on a similarly worded clause in the state constitution.

The post-seventies Contract Clause case law provided a federal avenue to protect public employees’ pension benefits, even in states that had no useful state-level constitutional doctrine.

Later Supreme Court cases formulated a three-part test for judging Contract Clause cases against state governments; a typical example is Energy Reserves Group, Inc. v. Kansas Power and Light Co. (1983), where the court applied the following analysis:

1. First, we look to see whether the state law “operated as a substantial impairment of a contractual relationship.” Impairments deemed by the court to be light or reasonably expected don’t implicate the Contract Clause. In particular, operating in a heavily regulated industry can itself make any later regulation reasonably expected.
2. Next, we determine whether the regulation had a “significant and legitimate public purpose,” which “guarantees that the State is exercising its police power, rather than providing a benefit to special interests.”
3. Finally, we see “whether the adjustment of the rights and responsibilities of contracting parties is based upon reasonable conditions and is of a character appropriate to the public purpose justifying the legislation’s adoption.”

Courts remain less deferential to legislative judgment when the state is a party to the contracts that are being abrogated. Still, in the hands of the Supreme Court, the Contract Clause continues to be a somewhat mushy balancing test that often tilts in favor of the state government, by finding that there was no substantial impairment for instance.

One might have thought that since 1991 the Contract Clause would have been strengthened further. Why 1991? Because that was the year in which Supreme Court Justice Clarence Thomas replaced Justice Thurgood Marshall, cementing a majority of Republican appointees who, on many issues, pursued reliably “conservative”-identified policies.

On the congressional power front, the Supreme Court held in 1992 that Congress had no power to force state legislatures or executive officials to carry out federal policy; it held in 1995 that Congress’s legislative power under the Commerce Clause was subject to meaningful limitations, and it held in 1996 that Congress lacked a general power to abrogate state sovereign immunity. On the property rights front, the court held in 1992 that state regulation that totally destroyed the value of private property counted as a regulatory taking and must be compensated; it held in 1994 (building on a previous 1987 ruling) that governments were limited in their ability to condition zoning permits on the landowners’ consent to make unrelated public improvements.

The 1990s were a time when one might have expected a revival of the Contract Clause—one the few provisions in the Constitution that explicitly seems to protect free-market values. Yet, no such revolution was forthcoming. In fact, the Supreme Court barely said a single interesting thing about the Contract Clause from the late 1980s to 2017. Why?

Perhaps because contracts are one area where state common-law courts have always had a strong role in defining the very field: what can be the subject of a contract, how contracts are made, how contracts are interpreted, and the like. (And the legislature can also enact, repeal, or modify such rules.) A doctrine that takes too strong a line in preventing changes to contracts would risk micromanaging the traditional primary role of state common-law courts—something federal judges in a predominantly common-law system, and especially conservative judges solicitous of federalism, are loath to do. Perhaps for this reason, the Supreme Court has also not been as active as some had hoped in enforcing the Takings Clause, despite the handful of decisions favorable to property rights mentioned in the previous paragraph.

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Today, the conservative Supreme Court majority seems even more entrenched than it previously had been. True, no Democratic appointee has been replaced by a Republican appointee in the past 29 years (in fact, the opposite has happened), but moderate Republican appointees have been replaced by arguably less moderate ones: Chief Justice John Roberts, and Justices Samuel Alito, Neil Gorsuch, and Brett Kavanaugh, as a whole, are probably more conservative than Justices William Rehnquist, Sandra Day O’Connor, Antonin Scalia, and Anthony Kennedy (though concepts like “conservative” are admittedly slippery when it comes to various aspects of judicial philosophy).

But, if we wanted to read the tea leaves as to whether a new revival of the Contract Clause was in the works, so far we wouldn’t find any indication of a substantial change. After decades of silence, the Supreme Court finally decided a Contract Clause case in 2018—Sveen v. Melin. And, by an 8–1 vote, the court rebuffed the Contract Clause claim. Sveen has nothing to do with public-employee pensions and isn’t even a case about state governments trying to abrogate their own contracts, but in the absence of better tea leaves, it’s the best clue we have to the current Supreme Court’s thinking about the Contract Clause.

Mark Sveen and Kaye Melin were married in 1997. Sveen already owned a life insurance policy, and, after his marriage, he named Melin as his beneficiary. In 2002, Minnesota passed a statute providing that “the dissolution or annulment of a marriage revokes any revocable . . . beneficiary designation . . . made by an individual to the individual’s former spouse.” The legislators’ thinking was presumably that people usually don’t want their ex-spouse to be their life insurance beneficiary, but they often don’t think about the need to change their beneficiary when they divorce; and so, once they die, their life-insurance proceeds will go to their ex, contrary to their intent.

Sveen and Melin divorced in 2007, and Sveen died in 2011. After Sveen’s death, the question was who would get the life-insurance proceeds: his ex-wife (according to the life insurance policy) or his adult children from a previous relationship (which would be the default if the statute were valid)? The federal trial court found that the statute was valid and awarded the life insurance proceeds to the kids. The appellate court reversed, finding that the statute violated the Contract Clause.

Justice Elena Kagan wrote the Supreme Court’s opinion reversing the appellate court. She restated the traditional rule from Energy Reserves Group, collapsing it into a two-part test. (1) First, we ask whether the impairment is substantial. “In answering that question, the Court has considered the extent to which the law undermines the contractual bargain, interferes with a party’s reasonable expectations, and prevents the party from safeguarding or reinstating his rights.” (2) Second, we look to “the means and ends of the legislation. In particular, the Court has asked whether the state law is drawn in an ‘appropriate’ and ‘reasonable’ way to advance ‘a significant and legitimate public purpose.’”

In this case, the inquiry stopped at the first step, because the Supreme Court found that there was no substantial impairment. At first glance, this seems counterintuitive: nobody likes to pay premiums, and nobody benefits from your life insurance until you’re dead, so naming the beneficiary is the “whole point” of the exercise. In fact, the amount of the premiums, the amount of the death benefit, and the identity of the beneficiary are the only really important terms of the contract. But Justice Kagan gave three reasons why the impairment was insubstantial.

• “First, the statute is designed to reflect a policyholder’s intent—and so to support, rather than impair, the contractual scheme.” This makes the scheme similar to any number of common-law presumptions designed to approximate the typical contractual party’s expectations. In this case, though the named beneficiary clearly remains the ex-wife, one might argue that there’s an omitted term, the “. . . except if we happen to get divorced” term that nobody thinks about—but that most would probably choose if pressed on the matter.
• “Second, the law is unlikely to disturb any policyholder’s expectations because it does no more than a divorce court could always have done.” The court awarded Melin a snowmobile and an all-terrain vehicle in the divorce decree; it could have altered the life insurance policy as well. True, it didn’t—but it could have, and anyone expects that all these matters are up for grabs in divorce court, which means there’s no reasonable expectation that’s one’s life-insurance beneficiary designation will survive a divorce.
• “And third, the statute supplies a mere default rule, which the policyholder can undo in a moment.” Because the statute only imposes a paperwork burden, it’s similar to recording statutes, which the Supreme Court has long upheld. Suppose a fraudulent seller sells the same plot of land to A and then to B. Normally A (as the first purchaser) would be entitled to the land (and B could sue the seller for damages). But recording statutes provide that interests in land aren’t valid unless you record the deed at a government office—so B would be entitled to the land if he was first to record. This statute changes the effect of contracts, but it doesn’t materially impair them because you can maintain the same result by complying with a paperwork burden. And the same is true of other statutes that impose notification or filing duties.

The end result was that the Minnesota statute was upheld. But this wasn’t a foregone conclusion. Consider Justice Neil Gorsuch’s arguments, which he expressed in a strong dissent—for himself alone. First, as the current court’s foremost originalist, he argued for an original understanding of the Contract Clause, which wouldn’t be limited to “substantial” impairments: early courts and commentators uniformly disapproved even minute impairments, while fully allowing legislatures to change contractual rules prospectively. But even under current doctrine, Justice Gorsuch argued, this statute should be invalidated. If this is considered a substantial impairment, it would surely be struck down because the state could achieve the same effect with a far less intrusive regulation: just have the state notify policyholders of their right to change their beneficiary, or impose this duty on insurance companies or divorce attorneys. So if one is to save the statute, it can only be (as the court does) by labeling the impairment “insubstantial.”

But how can this be an insubstantial impairment, when the choice of beneficiary is one of the most important terms in the contract? Maybe most policyholders would like the new presumption, but that depends on a stereotype that’s less and less true of divorcing couples. Indeed, there was some evidence that Sveen and Melin wanted to remain the beneficiaries of each other’s insurance policies, because the divorce was amicable and because they paid premiums from their joint checking account; for other couples (not Sveen and Melin, who had no joint children), that sort of arrangement would also be convenient for providing for minor children.

If a policyholder is so neglectful that he won’t change his beneficiary himself, how can we save the statute by noting that changing the beneficiary is a trivial matter of filing paperwork? How can we analogize this to what a divorce court could do, when divorce courts prospectively apply preexisting law whereas here the legislature has made up entirely new (and retroactive) law? And the analogy to recording statutes doesn’t necessarily hold up either, since recording statutes alter contractual remedies (they just change who gets the land and who gets to sue the seller for money) rather than altering a fundamental term of the contract.

So this is the Supreme Court’s latest word on the Contract Clause. We probably shouldn’t rely on getting new wisdom from the justices anytime soon, given that this is the first time they’ve said anything about the Contract Clause this millennium.

What, if anything, does this tell us about public-employee pensions?

One might be tempted to discount the significance of this case because it involves entirely private contracts—the contract between the policyholder and his insurance company—and we know that the Supreme Court is more deferential (and thus far more likely to uphold the statute) when private contracts are at issue. But note that the question of deference doesn’t come in until the back end of the inquiry when the court asks whether the substantial impairment was reasonably necessary to advance the state’s legitimate purpose. Here, they didn’t even get to that step: the court dismissed the claim at step 1, the existence of a substantial impairment, where deference shouldn’t matter.

So if a state seeks to alter public-employee pensions, there seems to be substantial leeway for the Supreme Court to say that the alteration is valid because the impairment isn’t substantial. (That governs the federal Contract Clause; as noted above, state courts applying their own state constitutional contract clauses are free to take stricter views. California has long applied its own contract clause, under the “California Rule,” in an exceptionally strict way—but even California case law has its escape valves, which, as we saw in a recent post, recent California cases have shown a willingness to exploit.)

There may be some irony here: a strict interpretation of the Contract Clause, whether or not according to its original meaning (as Justice Gorsuch would have it), is often labeled a “conservative” outcome. But as I’ve noted above, these sorts of labels are slippery when it comes to jurisprudence. Who would benefit the most from this “conservative” reading? Public-employee unions, whose position in the pension cases is often labeled a “liberal” position.

It just goes to show that interpretive techniques, if applied fairly, can often help litigants on either side. Just earlier this year, in Bostock v. Clayton County, Justice Gorsuch himself showed how an apparently “conservative” methodology of interpreting Title VII of the Civil Rights Act of 1964—according to the original meaning (in 1964) of the phrase “discriminat[ion] . . . because of  . . . sex”—leads to the apparently “liberal” result of protecting gay and transgender employees. Ironic or not, the “liberal” current understanding of the Contract Clause is likely to help modern-day “fiscally conservative” pension reformers.