The Contracts Clause limits the power of a state to alter the legal obligations created by preexisting contractual relationships. Specifically, Article I, §10, of the Constitution provides, “No State shall … pass any … Law impairing the Obligation of Contracts.” The apparent absolute proscription, however, has been tempered to accommodate the “inherent police power of the State ‘to safeguard the vital interests of its people.’ ” Energy Reserves Group, Inc. v. Kansas Power & Light Co., 459 U.S. 400, 410 (1983). In other words, the Contracts Clause is subject to the reserved powers of the states to protect the health, safety, and welfare of their citizens. Thus, not all state laws that alter contractual obligations are void under the Contracts Clause. In general, the test is one of reasonableness, in which a court must examine the expectations of the contracting parties, the severity of the impairment, and the public interest at stake.
From an analytical perspective, the examination of every Contracts Clause problem begins with three questions, each of which must be answered affirmatively to establish a potential violation of the clause:
See General Motors, Inc. v. Romein, 503 U.S. 181, 186 (1992). If each of these questions is answered affirmatively, the next step is to determine whether the state has acted reasonably under the circumstances. Energy Reserves Group, 459 U.S. at 411-413. Here, the substantiality of the state’s interest is measured against the extent of the impairment. Id. The specific elements of this analysis will be examined below.
By its terms, the Contracts Clause does not apply to the federal government. The Due Process Clause of the Fifth Amendment, however, may be triggered by federal legislation that has a substantial retroactive effect on a preexisting contractual relationship. The test for such retroactive legislation involves a modestly heightened rational basis review. See United States v. Carlton, 512 U.S. 26 (1994) (upholding the retroactive application of a federal tax law under the rational basis test, but noting that rationality in the context of retroactivity requires a somewhat stronger showing than rationality in the context of prospective applications).
Be careful not to confuse the due process concept, liberty of contract, with the interest that is protected by the Contracts Clause. The liberty of contract that comes into play under the Due Process Clause involves the freedom to enter into contracts, while the Contracts Clause protects one’s freedom from unreasonable state interference with the terms of a contract previously entered into. In other words, the Contracts Clause in no manner limits the ability of a state to legislate prospectively with respect to the substantive terms that may be included in future contracts or with respect to the conditions under which future contracts may be formed. The essence of a Contracts Clause violation is a change in state law that alters the obligations established by a preexisting contract.