The Contract Clause appears in the United States Constitution, Article I, section 10, clause 1. It states:
The framers of the Constitution added this clause due to fear that states would continue a practice that had been widespread under the Articles of Confederation - that of granting "private relief." Legislatures would pass bills relieving particular persons (predictably, influential persons) of their obligation to pay their debts. It was this phenomenon that also prompted the framers to make bankruptcy law the province of the federal government.
During and after the Revolution, many states passed laws favoring colonial debtors to the detriment of foreign creditors. Federalists, especially Alexander Hamilton, believed that such a practice would jeopardize the future flow of foreign capital into the fledgling United States. Consequently, the Contract Clause, by insuring the inviolability of sales and financing contracts, encouraged an inflow of foreign capital by reducing the risk of loss to foreign merchants trading with and investing in the former colonies. (See generally James W. Ely Jr., The Guardian of Every Other Right (Oxford Univ. Press 1998).)
At the time of the Civil War, this clause was one of the provisions upon which the Court relied in holding that the Confederation formed by the seceding States could not be recognized as having any legal existence. Today, its practical significance lies in the limitations which it implies upon the power of the States to deal with matters having a bearing upon international relations. In the early case of Holmes v. Jennison, Chief Justice Taney invoked it as a reason for holding that a State had no power to deliver up a fugitive from justice to a foreign State. More recently, the kindred idea that the responsibility for the conduct of foreign relations rests exclusively with the Federal Government prompted the Court to hold that, since the oil under the three mile marginal belt along the California coast might well become the subject of international dispute and since the ocean, including this three mile belt, is of vital consequence to the nation in its desire to engage in commerce and to live in peace with the world, the Federal Government has paramount rights in and power over that belt, including full dominion over the resources of the soil under the water area. In Skiriotes v. Florida, the Court, on the other hand, ruled that this clause did not disable Florida from regulating the manner in which its own citizens may engage in sponge fishing outside its territorial waters. Speaking for a unanimous Court, Chief Justice Hughes declared; “When its action does not conflict with federal legislation, the sovereign authority of the State over the conduct of its citizens upon the high seas is analogous to the sovereign authority of the United States over its citizens in like circumstances.”
Within the sense of the Constitution, bills of credit signify a paper medium of exchange, intended to circulate between individuals, and between the Government and individuals, for the ordinary purposes of society. It is immaterial whether the quality of legal tender is imparted to such paper. Interest bearing certificates, in denominations not exceeding ten dollars, which were issued by loan offices established by the State of Missouri and made receivable in payment of taxes or other moneys due to the State, and in payment of the fees and salaries of state officers, were held to be bills of credit whose issuance was banned by this section. The States are not forbidden, however, to issue coupons receivable for taxes, nor to execute instruments binding themselves to pay money at a future day for services rendered or money borrowed. Bills issued by state banks are not bills of credit; it is immaterial that the State is the sole stockholder of the bank, that the officers of the bank were elected by the state legislature, or that the capital of the bank was raised by the sale of state bonds.
Relying on this clause, which applies only to the States and not to the Federal Government, the Supreme Court has held that where the marshal of a state court received state bank notes in payment and discharge of an execution, the creditor was entitled to demand payment in gold or silver. Since, however, there is nothing in the Constitution prohibiting a bank depositor from consenting when he draws a check that payment may be made by draft, a state law providing that checks drawn on local banks should, at the option of the bank, be payable in exchange drafts was held valid.
Statutes passed after the Civil War with the intent and result of excluding persons who had aided the Confederacy from following certain callings, by the device of requiring them to take an oath that they had never given such aid, were held invalid as being bills of attainder, as well as ex post facto laws.
Other attempts to raise bill-of-attainder claims have been unsuccessful. A Court majority denied that a municipal ordinance that required all employees to execute oaths that they had never been affiliated with Communist or similar organizations, violated the clause, on the grounds that the ordinance merely provided standards of qualifications and eligibility for employment. A law that prohibited any person convicted of a felony and not subsequently pardoned from holding office in a waterfront union was not a bill of attainder because the “distinguishing feature of a bill of attainder is the substitution of a legislative for a judicial determination of guilt” and the prohibition “embodies no further implications of appellant’s guilt than are contained in his 1920 judicial conviction.”
During the New Deal Era, the Supreme Court made several fundamental changes regarding constitutional interpretation of the Commerce Clause, Due Process, and the Contract Clause. The changes came during a time of great crisis for the United States, and there was large public support for government programs which the Supreme Court had been ruling as unconstitutional. Finally, the Court fundamentally changed its interpretation of the constitution to accommodate the new programs. This "change" has been called The switch in time that saved nine.
In Home Building & Loan Association v. Blaisdell 290 U.S. 398 (1934), the Supreme Court upheld a Minnesota law that temporarily restricted the ability of mortgage holders to foreclose. The law was enacted to prevent mass foreclosures during a time of economic hardship. The kind of contract modification performed by the law in question was arguably similar to the kind that the Framers intended to prohibit. The Supreme Court held that this law was a valid exercise of the state's Police Power. It found that the temporary nature of the contract modification and the emergency of the situation justified the law..
Further cases have refined this holding, differentiating between governmental interference with private contracts and interference with contracts entered into by the government. Succinctly, there is more scrutiny when the government modifies a contract to alter its own obligations. (See United States Trust Co. v. New Jersey, 431 U.S. 1 (1977).)
The Supreme Court laid out the test for whether a law violates the Contract Clause in Energy Reserves Group v. Kansas Power & Light 459 U.S. 400 (1983). The test is a three part test. First, the state regulation must substantially impair a contractual relationship. Second, the State "must have a significant and legitimate purpose behind the regulation, such as the remedying of a broad and general social or economic problem." 459 U.S. at 411-13 Third, the law must be reasonable and appropriate for its intended purpose. This test is similar to rational basis review.
In United States Trust Co. v. New Jersey, the Supreme Court held that a higher level of scrutiny was needed for situations where laws modified the government's own contractual obligations. In this case, New Jersey had issued bonds to finance the World Trade Center and had contractually promised the bondholders that the collateral would not be used to finance money losing rail operations. Later, New Jersey attempted to modify law to allow financing of railway operations, and the bondholders successfully sued to prevent this from happening.
The Contract Clause prohibits states from enacting any law that retroactively impairs contract rights. The Contract Clause applies only to state legislation, not court decisions.
The Contracts Clause prevents only substantial impairments of contract, i.e. destruction or loss of most or all of a party's rights under an existing contract. However, not all substantial impairments violate the Contracts Clause.
To determine whether state legislation is valid under the Contracts Clause, the following three part test applies:
(i) Does the state legislation substantially impair a party's rights under an existing contract? If it does not, the state legislation is not invalidated by the Contracts Clause. If it does, such impairment will be valid only if it:
(ii) Serves an important and legitimate public interest; and
(iii) Is a reasonable and narrowly tailored means of promoting that public interest.