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 7^th Circuit case that posed this precise question.

            Empire Gas Corp. v American Bakeries Co. 840 F.2d 1333 (7^th 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.

Section 2-607(5)(a): Attorneys’ Fees as Consequential Damages

As noted in previous posts, the designation of a party as a merchant activates a number of special provisions under Article 2.  Among the most important is the warranty of merchantability under Section 2-314.  Subsection (1) to Section 2-314 states as follows:

Unless excluded or modified (Section 2-316), a warranty that the goods shall be merchantable is implied in the contract for their sale if the seller is a merchant with respect to goods of that kind.  Section 2-341(1)

What is or is not merchantable is set forth in Section 2-314(2):

            Goods to be merchantable must be at least such as

(a) pass without objection in the trade under the contract description; and

(b) in the case of fungible goods, are of fair average quality within the description;     and

(c) are fit for the ordinary purposes for which such goods are used; and

(d) run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and

(e) are adequately contained, packaged, and labeled as the agreement may require; and

(f) conform to the promise or affirmations of fact made on the container or label if any.

Sales of goods often involve several levels of distribution.  Initially, the sale of raw materials to be used in the manufacture of finished goods; sales from the wholesale to the retail level, and the sale to the retail customer. The warranty of  merchantability will be given at each stage provided the seller is a merchant.  Most of the time, the goods will meet the requisite standard of merchantability; sometimes they will not.  Very often this will occur in a situation involving a middleman who purchases goods for resale.  When the goods sold are not merchantable, and the middleman is sued for breach of warranty, specific rules kick in which the middleman should be aware of if he or she is to minimize exposure. 

Section 2-607(5)(a) contains rules of particular significance when goods are resold by a middleman to a third party.  That section states as follows:

Section 2-607(5)(a) states as follows:

Where the buyer is sued for breach of a warranty or other obligation for which his seller is answerable over

(a)  he may give his seller written notice of the litigation. If the notice states that the seller may come in and defend and that if the seller does not do so he will be bound in any action against him by his buyer by any determination of fact common to the two litigations, then unless the seller after seasonable receipt of the notice does come in and defend he is so bound.

This section enables the middleman who is being sued for the allegedly defective product to put his seller on notice of the litigation and provide him with the opportunity to defend against the litigation.  The failure of the original seller to do so will result in his being ‘bound in any action against him by his buyer by any determination of fact common to the two litigations.’

            As has been stated throughout these posts, it is highly recommended that the actual language of the statute be tracked in this type of situation.  ‘Coming close’ can result in litigation costs that could have been avoided.  In this regard however, and in connection with Section 2-607(5)(a), it must be noted that this section is permissive in nature, and that if a party does not strictly comply with Section 2-607(5)(a), she or he may still maintain a cause of action against her/his buyer for the breach of warranty.

This follows from the language of Section 2-607(5)(a) which states that the buyer ‘may give his seller written notice of the litigation.’  It is clearly permissive.  This question was thoroughly discussed by the Michigan Court of Appeals in Old Kent Bank v Kal Kustom Enterprises, which has impact in all states by reason of the uniformity provision of Section 1-103(1)(b).  See e.g. of In re Hispanic American Television Co., Inc., 113 B.R. 453 (Bankr.N.D.Ill.1990). 

The court in Old Kent discussed the permissive nature of Section 2-607(5)(a) as follows:

The language of M.C.L. § 440.2607(5)(a) is clear and unambiguous.   The statute's plain language reflects its discretionary nature.   Again, the statute states that where a buyer is sued for breach of warranty or other obligation for which his seller is liable, he “may give his seller written notice of the litigation.”

The court went on to state:

Further emphasizing the permissive nature of subsection 2607(5)(a) is the fact that a review of other subsections set forth in M.C.L. § 440.2607(5) indicates that the Legislature intentionally made some portions of the statute mandatory, and others permissive.   Subsections 2607(3)(a) and 2607(3)(b) contain the mandatory “must” in terms of notice.⁵  If the Legislature intended subsection 2607(5)(a) to be mandatory, it would have used similar mandatory language.

            I have been involved in cases where the original seller refuses to come into defend and in some situations completely ignores the notice sent.  This leaves the middleman in a very bad situation, for the original seller is the party best equipped to defend the product he sold.  As a result of this reality, at least one court has awarded attorney’s fees to the middleman who gave proper notice.  The starting point for this analysis is Section 2-714, which deals with buyer’s damages for accepted goods where seller has breached.  That section states as follows:

(1) Where the buyer has accepted goods and given notification (subsection (3) of Section 2-607) he may recover as damages for any non-conformity of tender the loss resulting in the ordinary course of events from the seller's breach as determined in any manner which is reasonable.

(2) The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount.

(3)In a proper case any incidental and consequential damages under the next section may also be recovered.

As noted in Section 2-714(3), in a ‘proper case’ incidental and consequential damages may be recovered under Section 2-715:

(2) Consequential damages resulting from the seller's breach include

(a) any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise; and

(b) injury to person or property proximately resulting from any breach of warranty.  

            In addressing the question of attorney’s fees, it must be noted that the attorney’s fees recoverable under Section 2-715(2)(a) are of a different nature than those claimed in a traditional contract litigation.  Attorney’s fees incurred in connection with a litigation in which a non breaching party is, in effect, forced to defend a claim from his buyer for defective goods sold by the original seller, are of a whole different nature.

            The precise issue was discussed by the United States District Court Acushnet Co. v. G.I. Joe’s, Inc., 2006 WL 2729555 (D. Or. Sept. 22, 2006). The case involved a breach of infringement warranty governed by Section 2-312(3) of the UCC.  Acushnet is the sole manufacturer of Titleist golf balls.  G.I. Joe’s purchased what it thought were Titleist balls from Cam Golf. They were in fact fakes.  Acushnet investigated further and learned that other fake Titleist balls were being sold by G.I. Joe’s elsewhere.

            Acushnet sued G.I. Joe’s, who in turn joined Cam Golf, Inc., the latter for breach of the warranty of infringement.  Acushnet and G.I. Joe’s settled with G.I. Joe’s paying $25,000 and incurring $19,300 in attorney’s fees. G.I. Joe sought recovery of both amounts in its action against Cam Golf.   The latter argued that attorneys’ fees were not recoverable, citing supposed authority for that proposition.  G.I. Joe responded:

G.I. Joe’s contends that Cam Golf has confused the issue of recovering attorney’s fees in prosecuting a lawsuit against the seller of goods with attorney’s fees incurred in defending a claim brought against the buyer by a third party. [at page 5]

 In addressing the matter, the court noted the permissive nature of Section 2-607(5)(a) and concluded that attorney’s fees were recoverable under Section 2-715(2)(a),  the Court quoted from Raymond v. Feldman 124 Ore. App 543, 546 (1993) as follows:

The general rule is that attorney’s fees are not recoverable in a breach of contract action unless authorized by statute or the agreement.  However  an exception to the general rule is when a party’s breach of contract involves the non breaching party in litigation with a third party  In such a case the non breaching party may be entitled to recover its litigation costs resulting from the separate action. [at page 6; Emphasis the Court’s]

These consequential damages are recoverable under the language of Section 2-715(2)(a), and the general policy of Section 1-305 which seeks to make non breaching parties whole, and has a special exception for awarding attorney’s fees when permitted under ‘other applicable rules of law’. The rule allowing attorney’s fees in defense of third party products is one of those exceptions. 

I suggest that parties who may be involved in situations in which Section 2-607(5)(a) create a document tracking the language of that section so that effective notice can be given in any situation in which it is required.

Merchants and the Economic Loss Doctrine

This post will conclude the discussion of who is, or may be a merchant under Article 2. The impact of ‘merchant status’ has been discussed in general.  However, there is one point which has not been touched on, which should be.  That involves the impact of the good faith definition under Article 2 for those states that have not enacted the amended definition of good faith in Article 1. The amended definition, if you recall requires ‘honesty in fact and the observance of reasonable commercial standards of fair dealing’,  per Section 1-201(b)(20). This applies to merchants and non merchants alike since the definitions in Article 1 apply to all substantive Articles of the Code per Section 1-102.

There are however, a significant number of states which have not adopted the amended definition of good faith*, but have instead, remained with the earlier definition of good faith which simply requires ‘honesty in fact in the conduct or transaction concerned’.  Under Article 2 however, if a party is classified as a merchant, the good faith definition [Section 1-103(1)(b)] is almost identical to the amended definition under Article 1 and thus, requires the observance of reasonable commercial standards of fair dealing in the trade by the party designated as a merchant.  Thus, the standard of conduct is elevated in the commercial arena.  Conversely, if a party is not designated as a merchant and the state law governing has not adopted the amended the definition of ‘good faith’, the party in question simply needs to demonstrate honesty.  Moreover, there are areas outside the Code which are dramatically impacted by whether or not a party is classified as a merchant under Article 2.

The latter point is dramatically illustrated in the case of Regents of the University of Minnesota v. Chief Industries Inc., 106 F3d 1409 (8^th Cir., 1997).  Among the program offerings at the University of Minnesota was an agricultural program which included the Southwest Research station, which was one of several such agricultural research stations operated by the University.   In 1985, the University decided to purchase a new grain dryer for the Southwest Station. After soliciting bids, the superintendent of the Research Station purchased a drying unit manufactured by a subsidiary of the defendant, Chief Industries.  In August of 1982, a fire damaged the structure to which the unit was attached.  The University brought a cause of action alleging that the electric solenoid valve, designed to stop the flow of fuel to the unit at a certain temperature, failed and was the cause of the fire.  In addition to damages for the allegedly defective grain dryer, the University sought damages to the connected structure.

The controlling statute in the case was Minnesota Section 604.10, which deals with the economic loss doctrine in Minnesota. ** That section states as follows:

Minn. Stat. § 604.10.  Economic loss arising from the sale of goods.

(a)  Economic loss that arises from a sale of goods that is due to damage to tangible property other than the goods sold may be recovered in tort as well as in contract, but economic loss that arises from a sale of goods between parties who are each merchants in goods of the kind is not recoverable in tort; (b) Economic loss that arises from a sale of goods, between merchants, that is not due to damage to tangible property other than the goods sold may not be recovered in tort; (c) The economic loss recoverable in tort under this section does not include economic loss due to damage to the goods themselves; (d) The economic loss recoverable in tort under this section does not include economic loss incurred by a manufacturer of goods arising from damage to the manufactured goods and caused by a component of the goods; and (e) This section shall not be interpreted to bar tort causes of action based upon fraud or fraudulent or intentional misrepresentation or limit remedies for those actions. [Emphasis added].

Hence, if the University of Minnesota was held to be a merchant, it would be barred from recovery for damage to the additional structure by the economic loss doctrine. The district court granted summary judgment against the University concluding that the University was a ‘merchant.'

The Court of Appeals phrased the matter on appeal as follows:

This brings us to this appeal's sole question:  is the University a “merchant in goods of the kind?"   That is, is the University a merchant with respect to grain drying heaters such as the one that allegedly caused the fire at the Southwest station?   If, as the district court concluded, the University is a merchant with respect to grain dryers, then it may not recover in tort under either the statute or [case law].  Regents of the University of Minnesota @ 1411

            In addressing the issue, the court first noted the definition of ‘merchant’ under Section 2-104(1), noting in its analysis two ways in which a party can become a merchant: ***

1.    By dealing in the goods involved;

2.    By way of specialized knowledge of the goods.

After quickly dismissing avenue number one—i.e.—that the University ‘dealt in goods of the kind’ the court turned its attention to attaining merchant status by way of specialized knowledge of the goods.  In addressing that question, and affirming the decision of the district court, the court of appeals stated:

In the present case, the University's knowledge and experience with respect to grain dryers constituted “knowledge or skill peculiar to the practices or goods involved in the transaction.”  Minn.Stat. § 336.2-104(1).

The University had purchased a number of such units over the prior thirty years, and had the advantage of a centralized purchasing department that solicited bids for the purchase.   Before purchasing the unit, the Southwest station's superintendent (who had been responsible for other such purchases) consulted a prominent expert in grain drying, who provided advice on such specifications for the unit as fan size and BTU.

            Creating ‘merchant’ status on the basis of ‘specialized knowledge’ opens the door to finding merchant status in situations outside of the normal professional in business.  While this may not be significant in all cases, it will be in some.  This is yet another example where leverage and vulnerability can be created where the other party never saw it coming.  This creates insecurity and facilitates a good settlement for your client.

*Among those states are: Illinois, Missouri and New York

**If you interested in an excellent article on the Economic Loss Doctrine, please check the following:

            Economic Loss Doctrine In All 50 States - Matthiesen ...

***The court did not mention the third way a party can become a merchant, which is through the ‘employment of an agent or broker or other intermediary who by his occupation holds himself out as having such knowledge or skill’.