Thursday, July 21, 2016

Requirement Contracts and The 'Stated Estimate

As of this post, we have seen the basic rule of Section 2-204(3) in operation multiple times within the text of the Code. By way of review, that section states:
Even though one or more terms are left open a contract for sale does not fail for indefiniteness if the parties have intended to make a contract and there is a reasonably certain basis for giving an appropriate remedy.
In the previous post we looked at the absence of a price term in a contract, and saw that per Section 2-305, the parties can create an enforceable contract without a price in place.   That, like the general rule of Section 2-204(3), requires the intent of the parties to enter into such an agreement.
            We now look at a situation in which no specific quantity need be stated in order to have an enforceable contract.  In this instance, the quantity term is supplied by the ‘requirements of the buyer’ or ‘the output of the seller’.  This situation is governed by Section 2-306(1):
(1) A term which measures the quantity by the output of the seller or the requirements of the buyer means such actual output or requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate or in the absence of a stated estimate to any normal or otherwise comparable prior output or requirements may be tendered or demanded.
Although the good faith requirement for output and requirements contracts is mandated by Section 1-304, Section 2-306(1) explicitly states the good faith requirement in output and requirements contracts. 
            The good faith component has parameters placed upon it, in that no output or requirement may ‘be unreasonably disproportionate to any stated estimate’.  In the absence of any stated estimate, no output or requirement may be tendered or demanded which is not ‘normal or otherwise comparable prior output or requirements’. 
It is clear from the text that if no quantity is stated the seller’s output would be comprised of all units produced by the seller.  Similarly, if no specific amount of requirements are stated, the buyer would be able to request all units to fulfill its needs.  Both of course are subject to the limiting language of ‘normal or otherwise comparable output or requirements’, and the good faith requirement of ‘honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade’.
            A question appears to have arisen as to what happens when the buyer provides a stated estimate and then chooses not to purchase any units. Does the seller have any rights in that situation?  A reading of the text of Section 2-306(1) would appear to allow the seller to tender units to the buyer as long as the amount tendered was not ‘unreasonably disproportionate’ to the stated estimate.  That however is not the result reached in a 7th Circuit case that posed this precise question.
            Empire Gas Corp. v American Bakeries Co. 840 F.2d 1333 (7th Cir., 1988)  Empire Gas was a retail distributor of propane, and a provider of conversion units which convert gas engines to propane engines.  The major source of profit for Empire was in the contract to purchase propane from Empire which accompanied the sale of the conversion units  During the contract period in question, gasoline prices had risen dramatically resulting in American Bakeries’ decision to convert to propane and its resulting contract with Empire. The first contract drafted by Empire was rejected by American, but the subsequent contract was accepted and executed, which required American to purchase approximately three thousand (3,000) [conversion] units, more or less depending upon requirements of Buyer.
            In discussing Section 2-306, the court posed the question of whether or not a buyer who makes a ‘stated estimate’ of its anticipated needs is actually bound by that estimate as stated in the contract when a buyer decides to purchase no units, or whether that estimate, embodied in a signed writing, is irrelevant and unenforceable.  Judge Posner stated the question as follows:
So we must decide whether the proviso should be read literally when the buyer is demanding less rather than more than the stated estimate.
The court discussed the applicability of the ‘stated estimate’ language to a buyer who orders more than a stated estimate. The court reasoned that without the limiting language, a buyer could order significantly more goods when the market was favorable. In discussing the issue, the court noted that the statute and Official Comment 3’ points to symmetrical treatment of the overdemanding and underdemanding cases.’
            Despite the clear language of the statute and comment 3, the Court concluded that the stated estimate of the buyer was of no legal significance when the buyer chose to purchase no units. In reaching its conclusion, the court noted case law and respected commentary which stands for the proposition that a buyer can reduce its requirements to zero as long as it does so in good faith.  Such a reading is consistent with the statute when a buyer has agreed to buy all of its requirements from a particular seller.  Clearly, if it turns out that there are no requirements, and that this is the result of a good faith decision by the buyer, there is no breach.
             I do not however, agree with the conclusion that a stated estimate by a buyer is of no legal significance when the buyer does not purchase any goods under the requirements contract.  First, and foremost, such a result is in conflict with the clear language of the statute.  It is clear from the statute that a seller in such a situation has the right to tender a quantity as long as the quantity is not ‘unreasonably disproportionate to any stated estimate’. 
            The purpose of the ‘stated estimate’ is easy to grasp.  It allows a seller of goods to make preparations for the buyer while being able to fulfill other orders.  If, as in Empire Gas, seller knows that its buyer is committed to purchasing a certain number of units, it can procure materials to accommodate that order.  Additional production may also be required.  The stated estimate allows the seller to prepare.  I emphasize that the buyer can avoid this result by contracting for ‘all requirements’, rather than a stated estimate. 
            As Judge Posner notes, the comments clearly indicate the drafters’ intent that the "the agreed estimate is to be regarded as a center around which the parties intend the variation to occur."  A fair read of that language leads to the conclusion that the drafters considered the ‘stated estimate’ to have legal significance.  Moreover, there is nothing in the text or the comments which supports limiting the applicability to over purchases by a buyer as opposed to no purchases by the buyer.
            I emphasize again that the case involving the ‘stated estimate’ is different than a pure requirements contract.  If a contract is for ‘all requirements’ of a buyer, and if the buyer in good faith has no requirements, the buyer is not liable. On the other hand when, as in this case, the parties negotiated a contract with a stated estimate of requirements under that contract, I believe that the buyer is bound by that estimate within the variations permitted by the Code.  The buyer could easily have limited exposure by simply contracting for ‘all requirements’.
            Finally, of great significance is the recognition throughout the Code of freedom of contract as an affirmative principle of the Code as embodied in Section 1-302(a).  Moreover, recognizing the agreement of the parties is an underlying principle upon which the Code was drafted per Section 1-103(a)(2).  The parties in Empire agreed that American Bakeries would purchase approximately 3,000 units.  This term was negotiated by both parties.  It is my opinion that the ‘stated estimate’, agreed to by the parties, has legal significance and is binding.

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