I stated in the previous post that “Contracts are good.” I didn’t, however, say that contracts were sacrosanct or could never be broken (or that you can wave the word “Contract!!” like a magic wand, as if to repel the snakes from Ireland). But that is indeed the argument advanced by several media pundits as a justification for allowing rockstar derivatives traders to keep $165M in bonus pay larded out from the vast $170 billion-dollar corpus of the US taxpayers’ AIG bailout. To quote Andrew Sorkin in the New York Times yesterday, “the fundamental value in question here is the sanctity of contracts.” In Sorkin’s moral view of capitalism, it’s a stark dichotomy: you either “swallow hard” and pay the rockstars, or you engage in the “tearing up” of contracts.

It’s just not that simple. Contracts are a set of rules that spell out the parties’ mutual intentions and individual obligations for a jointly-agreed undertaking. Good contracts not only spell out the structure and the rules, they spell them out taking into account a wide variety of alternate realities — not just what everyone had in mind when they first started to negotiate and everything was kumbayah — but also how things should go under…weird circumstances. Wierd circumstances like floods, fires, earthquakes, strikes, martial law, and the US government taking over your company due to a collapse of the financial system.

Suppose you and I make a contract for me to tap-dance on your coffin on the date of your funeral, and in exchange I will receive a $1M dollar “retention bonus” (for sticking around until you are actually dead). You fulfill one of your obligations under the contract by showing up (dead), thereby providing me the necessary coffin to tap-dance upon. (And I made sure that you pre-arranged payment to me via a third party, since you wouldn’t be there to hand me my bonus check.) Just before I am about to start my tap-dance routine, the law of gravity is rescinded, causing me to fly off the earth, and causing your coffin to fly off the earth, too. I couldn’t tap-dance on your coffin, as I contracted, if I wanted to. Weird circumstances.

In writing good contracts, good contract lawyers actually spend a fair amount of time thinking along these “What are all the bad things that could go wrong?” lines. US commercial law has a doctrine for dealing with weird circumstances called “force majeure.” A force majeure term in a contract excuses either or both parties from their obligations under an agreement, because it is no longer possible to perform as promised due to circumstances beyond the parties’ control. (The great majority of professionally negotiated contracts contain a force majeure clause.)

My response to Mr. Sorkin’s argument in favor of paying the AIG rockstars used force majeure as an example of one of the many ways that a contract could be interpreted to excuse non-performance. I stated that AIG was extremely likely to be able to be excused from paying the bonuses due to the collapse of the financial system, and without breach under the actual terms of the contract — IF there were a force majeure clause in the contract to rely on. Here’s the link to my AIG bonuses / force majeure comment on the New York Times (and here’s a permalink to the comment text which I have placed here on the Arborlaw site.)

But, we don’t have to stop at force majeure, the issue which I chose. There are at least a dozen more legal theories that would support withholding those AIG bonuses. The New York Times has a pretty nice roundup of the main legal theories here: “Room for Debate: When Bonus Contracts Can Be Broken,” The New York Times (March 17, 2009), and Lawrence Cunningham makes an excellent and concise summary of the basic legal principles in an op-ed comment here: “A.I.G.’s Bonus Blackmail,” The New York Times (March 18, 2009).

Score another one for the contract attorneys (maybe).