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.

Battle of the Forms: No Battle

The Reply Doctrine of Section 2-201(2) creates a logical introduction to Section 2-207—Battle of the Forms.  In fact, Section 2-207(1) uses language almost identical to Section 2-201(2) insofar as it speaks of a ‘written confirmation’ of acceptance.  Before turning to the text and meaning of Section 2-207, it should be noted that this section has been heavily litigated with differing interpretations as to its meaning.

            Section 2-207 provides an opportunity to demonstrate the connectivity between Code sections, and the intertwining of meaning.  The skilled advocate creates a logical sequence through all of that with a favorable outcome.  For example, standing alone you have fairly clear statutory text for Section 2-201(2).  ‘A writing in confirmation’ is very clear when stated like the example given in the last post.  Of course, in reality it is rarely done so cleanly.  Rather, the writing in confirmation may be a simple purchase order, with no specific confirmation language, and courts have so held.

            The Code sections which immediately come into play are Sections 1-201(b)(3),(12), the definitions of agreement and contract.  This in turn activates Section 1-303 and the elements of course of performance, course of dealing and usage of trade. There are also supplemental principles of law which may apply pursuant to Section 1-303(b). As facts are added to the substantive provisions of the statute, the Code sections come to life with new interpretations.  These various interpretations create a very dynamic and fertile ground for structuring arguments or drafting provisions in a manner most favorable to your client.

            As for Section 2-207, I believe that section can be understood by a careful reading of the text of the statute.  As I was taught ‘The answer is always in the Statute.’  At the outset, one must remember that Section 2-207 is predicated upon an offer having already been made by either the buyer or seller, for the section speaks in terms of a ‘definite and seasonable expression of acceptance or a written confirmation’.  There can be no acceptance or written confirmation unless an offer has been made. [Unless of course, someone is using Section 2-201(2) to solidify a deal that may or may not have existed.]

Section 2-207(1) states as follows:

(1) A definite and seasonable expression of acceptance or a written confirmation which is sent within a reasonable time operates as an acceptance even though it states terms additional to or different from those offered or agreed upon, unless acceptance is expressly made conditional on assent to the additional or different terms.

The rule of Section 2-207(1) is clear and straightforward.  It contemplates an acceptance or written confirmation of an offer, with the acceptance presenting additional terms to those offered.  The rule is that the acceptance is binding unless the acceptance is made conditional on the offeror’s assent to the additional terms.  In other words, it is a ‘take it or leave it’ acceptance.

            For example, Seller offers buyer 1,000 pairs of shoes for $18.00 per pair with no stated delivery terms.  Buyer sends the following response:

I accept your offer to buy 1,000 shoes at $18.00 per pair, delivery to be made in five separate lots of 200 units per lot.

Under Section 2-207(1), Buyer has accepted Seller’s offer.  Delivery in five lots is not a condition to Buyer’s acceptance, simply a statement or request.

If on the other hand, Buyer had demanded inclusion of his delivery term as a prerequisite to the acceptance, there would be no acceptance under Section 2-207(1).  In that scenario, Buyer’s proffered acceptance might read as follows:

I accept your offer to buy 1,000 shoes at $18.00 per pair.  However, I need delivery in five separate lots of 200 units per lot or I will not do the deal.

Buyer has made his ‘acceptance’ conditional upon Seller’s acquiescence to his delivery demand.  Hence, no acceptance.

            Section 2-207(2) explains what happens when additional terms are proposed but not made as a condition to the acceptance:

The additional terms are to be construed as proposals for addition to the contract. Between merchants such terms become part of the contract unless:

(a) the offer expressly limits acceptance to the terms of the offer;

(b) they materially alter it; or

(c) notification of objection to them has already been given or is given within a reasonable time after notice of them is received.

In the first part of the example given above, Buyer’s request for delivery in five lots would be treated as a ‘proposal’ for addition to the contract.  If both parties involved in the transaction are merchants, Buyer’s delivery proposal will become part of the contract unless one of the contingencies covered in Section 2-207(2) occurs.  For example, one question might become whether the proposed delivery terms ‘materially alter’ the original offer.  Trade custom would have particular relevance here.

            It is interesting to note that the first contingency stated in 2-207(2) goes back to the original offer which set things in motion.  If that offer is a ‘take it or leave it’ proposal, no additional terms will be incorporated into the contract.  If the additional terms ‘materially alter’ the offer, they will not be included.  And finally, if a notice of objection to the additional terms has been given within a reasonable time, the terms will not become part of the contract.       

            So, at this point we have two take it or leave it scenarios.  Under Section 2-207(1) a ‘take it or leave it’ acceptance results in no acceptance.  Under Section 2-207(2), if the original offer was a ‘take it or leave it offer’ no new terms will be considered.  The reality is that these situations rarely occur in orderly communications such as those hypothesized above.  It happens under time and business pressures, with many transactions ongoing.  Sometimes, forms don’t get read, and if they are, often are not understood.  So, there is no formal contract and you may have writings going back and forth with contradictory terms.

            Yet, the deal goes forward.  Why?  Everybody wants to make money and they adopt the ‘nothing will go wrong’ approach, and of course, sometimes the deal goes south.  The beautiful wood cabinets called for in communications were not up to the buyer’s expectations. There is no finalized contract.  Negotiations fail, and litigation ensues.  At this point, Section 2-207(3) takes control of what happens.  That section states as follows:

 Conduct by both  parties which recognizes the existence of a contract is sufficient to establish a contract for sale although the writings of the parties do not otherwise establish a contract. In such case the terms of the particular contract consist of those terms on which the writings of the parties agree, together with any supplementary terms incorporated under any other provisions of this Act.

The net effect is that the written portion of the contract will consist of whatever written terms are agreed upon between the parties, date and quantity for example.  Contradictory terms will be eliminated and the agreed written provisions will be supplemented by the UCC. 

The application of Section 2-207(3) can have an enormous impact on a case.  For example, Seller may have had some very specific warranty provisions that are part of all of his deals.  If Buyer has presented a contradictory term—very common in a purchase order, you have the classic situation.  If Seller’s warranty has been eliminated because it is contradictory to Buyer’s purchase order, it is highly likely that the warranties supplied by the Code will be more favorable to the Buyer than the ones contained in the documents Seller prepared.

Mixed Transactions: UCC or Non-UCC?

As noted in a previous post, although Article 2 is entitled ‘Sales’, the actual scope of Article 2 as stated in Section 2-102 is that its coverage applies to ‘transactions in goods’.  Some transactions involve a combination of sales and services and have been labeled ‘mixed transactions’.  By way of simple example, assume patient ordered a set of dentures from her dentist which he later placed into her mouth.  You have the sales element in the actual sale of the dentures to the patient and you have the service element in measuring for the dentures and installing them into the patient.  These are the facts from a case I used when teaching Sales.  The court found that the transaction between the patient and the dentist was predominantly a service, not a sale. [Cook v Downing 1994 OK CIV APP 178, 891 P2d 611, 27 UCC Rep. Serv. 2d 837 (Ct. App. Div 1 1994) ]  Therefore, the Uniform Commercial Code did not  apply.

Courts have used several tests to determine whether or not a mixed transaction is a sale or a service.  The two most common are posed in the form of questions:

Is the gravamen of the transaction a sale or a service?

Is the primary or predominant purpose of the transaction a sale or a service?

Within these broad based questions, a variety of factors are discussed by the courts.  Before turning to some of these factors, a more fundament question must be asked:

What difference does it make whether a transaction is determined to be a sale or service?

The importance of the classification as a sale of goods or a service lies in the rules governing the drafting of contracts, and, if necessary, determines the governing rules when battles are fought.  As to the drafting of documents if that is in play, the UCC gives great weight to the agreement of the parties and freedom of contract as a general principle.  [Both of these topics have been discussed in earlier posts.]  It is difficult to imagine a more clear set of statutory guidelines with the corresponding ability to impact transactions than those given by the Uniform Commercial Code.  Someone drafting a contract who wants the UCC to govern a mixed transaction should definitely create a provision in the contract stating that it is the intention of the parties to treat the transaction as a sale.   While this is not enough to make a non-sale a sale, it is something the courts have looked at in classifying a mixed transaction contract.  As a general drafting strategy, I encourage a statement of intent where it is important and might ultimately be of use by the court in making its determination.

            If the question arises in the litigation context, the issue becomes: Where do you want to fight the battle?  That will turn on your knowledge base and skill set.  Where are you better equipped to fight?  Do you have better weapons under the Uniform Commercial Code or outside the Code?  That will sometimes be a fact specific analysis which in turn is determined by the relevant Code provisions. For example, statute of limitations protections; warranty provisions; notice provisions and the like.  Obviously, if you have a strong knowledge base in the Uniform Commercial Code, you will generally prefer to have matters resolved within the Code.  Your opponent is not likely to be as well versed in the Code as you are, so he or she will try to keep the case out of the Code, perhaps resolving it through contract law or the law of negligence.  So the answer to the question posed really boils down to what rules do you want to play under?  It can be viewed as something akin to home field advantage.

Mixed contracts occur in a wide variety of settings.  One of the most frequently litigated settings is found in the sale of computer systems.  Often these systems involve two elements—creation and design of the system—and the ultimate sale of the system.  They also involve the sale of software and hardware, both of which have been determined to be goods by the majority of courts.

Micro Data Base Systems, Inc. v. Dharma Systems, Inc 148F3d 649 (7^th Cir. 1998) involved a dispute between two software companies—MDBS and Dharma Systems.  The underlying facts began with an IRS call for bids for a contract to improve its computer capabilities. Unisys Government Systems wanted to bid on the contract.  Toward that end, Unisys entered into a contract with MDBS for the provision of a workstation management system designed to be used by the IRS.  MDBS subsequently entered into a contract with Dharma who agreed to adapt its proprietary software program for use in the system MBDS would be providing to Unisys for sale to the IRS.  MBDS agreed to pay a $125,000 licensing fee for the use of the program and an additional $125,000 for adapting the program to meet the requirements of MBDS.

In the opinion, and with respect to the characterization of the transaction, the court noted that the law of the two states involved differed on whether the sale of custom software is a ‘good’ and hence subject to Article 2.  In Indiana, the sale of custom software has been held to be a service, whereas in New Hampshire, the sale of custom software has been held to be the sale of a good.  The court noted that under New Hampshire law the determination hinges on which aspect of the transaction ‘predominates’—the sale or the service. 

In reaching its determination that the contract was for the sale of goods, the court likened the services aspect of the contract to the labor that would attend the manufacture of any product.  In supporting this analysis the court stated:

                   

We doubt that it should even be called a ‘hybrid sale’, for this would imply that every sale of goods is actually a hybrid sale, since labor is a service and labor is an input into the manufacture of every good. Micro Data Base Systems, Inc,.at 655.

            There are cases going both ways on the question of whether developmental software which is later sold is a sale or a service.  The case under discussion is illustrative of the importance of the choice of law provisions of the Code [discussed in an earlier post].  If the parties had contracted for Indiana law to apply which would have been allowable under Section 1-301, the result in the case would have been different.  This is one of the reasons that it is so important to check the law of the various jurisdictions involved in a particular transaction so that parties can intelligently draft contracts which govern their transaction.

What are the Goods?

As of this writing, most of Articles 1 and 3 have been completed, and while there are other sections which could be discussed in Article 3, I am confident that anyone who understands the posts to date will be able to analyze those sections.  Going forward, I will be combining posts from Articles 2, 7, and 9.  Article 2 deals with sales of goods; Article 7 deals with movement and storage of goods via documents of title; and Article 9 deals with secured financing, and while there are many types of non goods collateral, Article 9 has many provisions which deal with the secured financing of goods at the wholesale and retail level. 

At the outset, it must be noted that although Article 2 deals with sales, the scope of Article 2 applies to ‘transactions in goods’:

Unless the context otherwise requires, this Article applies to transactions in goods; it does not apply to any transaction which although in the form of an unconditional contract to sell or present sale is intended to operate only as a security transaction nor does this Article impair or repeal any statute regulating sales to consumers, farmers or other specified classes of buyers.

                                      

                                                                                    Section 2-102

Most of the time, the applicability of Article 2 will be very straightforward—the transaction involved will be a typical sale of goods and Article 2 will apply.  In some situations however, the transaction involved will be a combination of a sale and a service requiring further analysis to determine whether or not a particular combined transaction is within the scope of Article 2.

            Before addressing the scope issue as it relates to mixed transactions, a more basic question must be addressed; namely, what are ‘goods’, the essential ingredient of Article 2. Goods are defined under Section 1-205 as follows:

(1)  "Goods" means all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale other than the money in which the price is to be paid, investment securities (Article 8) and things in action. "Goods" also includes the unborn young of animals and growing crops and other identified things attached to realty as described in the section on goods to be severed from realty (Section 2-107).

Goods, therefore, are tangible personal property which are ‘movable’ at the time of identification to the contract for sale.  Note that when money is used as a payment mechanism, it is excluded from the definition of goods.  If however, money is being sold as a commodity, it will come within the definition of goods.  This point is specifically addressed in comment 1 to Section 2-105 which states as follows:

Goods is intended to cover the sale of money when money is being treated as a commodity but not to include it when money is the medium of payment.

In order for an interest in goods to pass, the goods must be ‘existing and identified’:

Goods must be both existing and identified before any interest in them can pass. Goods which are not both existing and identified are "future" goods. A purported present sale of future goods or of any interest therein operates as a contract to sell.                     Section 2-105(2)

Several exceptions/qualifications to this general rule are contained in Section 2-107 which is cross referenced in Section 2-105(1).  Section 2-107(1) states as follows:

A contract for the sale of minerals or the like (including oil and gas) or a structure or its materials to be removed from realty is a contract for the sale of goods within this Article if they are to be severed by the seller but until severance a purported present sale thereof which is not effective as a transfer of an interest in land is effective only as a contract to sell.

There are three situations contemplated by Section 2-107(1):

1.    Sale of minerals ‘or the like’, specifically including oil and gas;

2.    Sale of a structure to be moved from realty;

3.    Sale of the materials of a structure to be removed from realty.

In order for a sale of the foregoing to be within Article 2, severance of those items must be undertaken by the seller.  Further, until severance, there can be no present sale of those items unless there is an accompanying transfer of the real estate interest.  Absent such a real estate transfer, any contract for the sale of the items listed will be treated’ only as a contract to sell’.

            The foregoing is consistent with basic real estate law. Oil, gas and mineral rights generally are treated as part of the real estate on which they are located.  Hence, absent a sale of the land, there is no sale of these goods.  This is also consistent with Article 9 which characterizes oil, gas and mineral rights as ‘as extracted collateral’, which is defined under Section 9-102(a)(6) as follows:

                         "As-extracted collateral" means:

(A) oil, gas, or other minerals that are subject to a security interest that:

(i) is created by a debtor having an interest in the minerals before extraction; and

(ii) attaches to the minerals as extracted; or

(B) ….

While the oil, minerals and gas are in the ground, they are treated as real estate.  Upon extraction they become goods, and hence within the scope of a secured transaction under Article 9.

            The scenario contemplated by Section 2-107(1) is to be distinguished from the situation where the goods involved are attached to realty but are capable of removal without ‘material harm’ to the realty:       

A contract for the sale apart from the land of growing crops or other things attached to realty and capable of severance without material harm thereto but not described in subsection (1) or of timber to be cut is a contract for the sale of goods within this Article whether the subject matter is to be severed by the buyer or by the seller even though it forms part of the realty at the time of contracting, and the parties can by identification effect a present sale before severance.

 In the situation contemplated by Section 2-107(2), severance can be made by either party, and the parties can conduct a present sale of those goods before severance by identification of the goods involved.