Lecture 5: Allocation of Obligations & Risks

Foundational Principles: Pacta Sunt Servanda and Risk Allocation

• Parties are bound by their agreement, having been free to determine the content of their obligations.

  • The equality in the values exchanged is considered immaterial.

• Court Review: Courts are generally only concerned with the fairness of the negotiation process and the validity of the agreement.

• Risk Assumption: Business inherently involves risk. A speculative transaction is deemed to accept a certain degree of risk, even if the party was not fully aware of that risk upon entering the contract.

• The Rock and the Hard Place: The general rule (the "rock") is pacta sunt servanda. The opposite extreme ("the hard place") is breach of contract. Force majeure and hardship represent exceptions (relief mechanisms) needed between these two extremes.

Force Majeure

• Non-performance by a party is excused if that party proves that the non-performance was due to an impediment beyond its control, and that it could not reasonably have been expected to have taken the impediment into account at the time of the contract's conclusion, or to have avoided or overcome it or its consequences.

Cumulative Conditions for Granting Relief (FM)

1. Impediment beyond the control of the affected party.

2. Unforeseen circumstances at the moment of conclusion of the contract.

   • This requires that there was No allocation of the risk contractually or implicitly.

   • If a risk (like a pandemic) was foreseeable to lawyers, the "unforeseen event" condition may not be fulfilled. Sometimes, the duration or exceptional nature of an event (like a lockdown) might qualify as unforeseeable.

3. The impediment is Making performance absolutely impossible.

4. The affected party must Give notice to the other party without undue delay (ASAP). Notice serves to invoke the relief and describe the impossibility being claimed.

5. Burden of proof rests on the affected party.

Consequences of FM 

• General Relief: The affected party is excused in the event of non-performance. If relief is granted, no compensation needs to be paid.

• Performing Despite Impossibility: An affected party who performs could be held liable, and if they indicate they will still deliver, the moment of relief is gone ("Can’t go back").

• Definite Impossibility: If the impediment is definite, it results in an excuse for non-performance.

• Temporary Impossibility: If the impediment is only temporary, the excuse results in a suspension of the obligations of the affected party for a period that is reasonable, having regard to the effect on contract performance.

  • The delay is not necessarily 1-on-1 equivalent to the time of interruption; it depends on the effect on the transaction process.

  • Performance is always in the future; the suspended obligation does not have to be performed retroactively.

FM in relation to Monetary Obligations and Unascertained Goods

• Monetary Obligations: It is very difficult (but not impossible) to invoke FM regarding a monetary obligation.

  • Money is generally considered a generic or unascertained good.

  • The principle Genera non pereunt (generic goods do not perish) means delivery of unascertained goods (like generic money or raw materials) can only become more expensive, not impossible. This usually points toward Hardship, not FM.

Hardship

• Applies where performance is not impossible, but it has become more difficult, extremely onerous, or unprofitable (often economically onerous, lucrum cessans).

• occurs when events fundamentally alter the equilibrium of the contract because either the cost of performance has increased or the value of the performance received has diminished.

Conditions for HS

1. The events occur or become known to the disadvantaged party after the conclusion of the contract.

2. The events could not reasonably have been taken into account by the disadvantaged party at the time of the conclusion of the contract (unforeseen circumstance).

3. The events are beyond the control of the disadvantaged party.

4. The risk of the events was not assumed by the disadvantaged party.

Consequences of HS

• Option 1: Hold affected party to original terms: May involve granting specific performance or damages.

• Option 2: Grant relief to the affected party.

• Option 3: Judicial Adjustment: Give the court the power to adjust the contract provisions to the new circumstances.

HS and Favour Contractus

• The goal is to favor the revision of the contract to restore the lost contractual equilibrium and preserve the initial reasonable expectations of mutual benefits.

• The disadvantaged party is entitled to request renegotiations without undue delay, indicating the grounds. 

• This creates an obligation to renegotiate in good faith ('obligation de moyen' / 'best effort'). However, there is often no mandatory obligation to renegotiate unless a contractual clause requires it.

  • conflicts slightly with freedom of contract. Choosing who you want to contract with 

Hardship Clauses

• These clauses specifically deal with situations where performance becomes "excessively onerous". They typically bind the parties to negotiate alternative contractual terms within a reasonable time upon invocation, provided specific conditions (unforeseeability, beyond control, and excessive onerousness) are met.

Price Indexation Clauses

• Mechanism: Provides for the automatic adaptation of the price if certain events occur. The price is annually indexed based on a formula using a new index and a basic index (e.g., general index or specific index like raw materials or wages).

• Risk Allocation: If a contract contains a price indexation clause relating to variations in the cost of materials and labor, A is not entitled to request renegotiation due to extra taxes imposed on employers, as the indexation clause applies.

• Exception: If the substantial increase in costs is due to unforeseen events not linked to the indexation clause (e.g., new environmental regulations imposing export duties), A might be entitled to request renegotiation.

Variability Clauses

• Designed to compensate for the volatility of money markets, used in short-term or long-term agreements.

  • These clauses can be unlimited, or structured with a maximum (cap) and/or minimum (floor) to define the range of acceptable volatility.

  • Example: A cap ensures that even if interest rates rise above 7, the payer only pays 7.

Currency Clauses

• Determine who bears the currency risk when parties are established in different countries with potentially different currencies.

  • Election: Specifies a single currency for all payments (e.g., EUR, USD).

  • Option: Allows one party (e.g., the buyer) the choice to pay the price denominated in one currency (Dollars) using another currency (Pesos).

  • Currency Conversion: Clauses specify the method and rate used for converting foreign currency, often referencing published rates (e.g., the Wall Street Journal) or a company's internal procedures.

Set-off

• Mechanism to make transactions more efficient by reducing or discharging a debt by offsetting it against a mutual debt owed in the other direction.

• Principle

• Set-off involves obligations of the same kind between two parties.

  • This includes monetary debts, even in different but freely convertible currencies, or other performances of the same kind.

  • Example: If A owes B $100 and B owes A $50, A can set off $50 and only pay B the remaining $50.

Conditions for Set-Off

1. The first party is entitled to perform its obligation.

2. The other party's obligation is ascertained as to its existence and amount.

3. Performance is due.

   1. If there is a dispute over the existence or amount of the debt, a set-off cannot occur (to maintain legal trust and law).

Legal Mechanisms for Set-Off

• Automatic Set-Off: Some legal systems apply set-off automatically if strict conditions (same kind, certain, and due claims) are met. This provides certainty against risks like bankruptcy.

• Set-Off by Declaration/Notice: Other legal systems require a declaration or notice from one of the parties. The notice should specify the obligations to which it relates, which is important for factors like interest rates, limitation periods, and bankruptcy proceedings.

• Judicial Set-Off: Courts may order set-off if parties have a dispute.

Consequences of Set-Off

• Set-off discharges the obligations. If the obligations differ in amount, set-off discharges the obligations up to the amount of the lesser obligation. Set-off takes effect from the time of notice or when the conditions are met.

FM vs HS

• Think of Force Majeure as a massive, immovable brick wall blocking a highway: it makes travel impossible until the wall is gone.

• Hardship is like discovering the only bridge across a river has been washed out, forcing you to take a 500-mile detour around the mountains. Travel is still possible, but it has become dramatically more difficult and costly, fundamentally altering the time and resources you expected to spend.