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.

Article 2: Going Forward

As of this post, we have looked at some of the basic concepts in the formation of a contract under Article 2 including: the Statute of Frauds under Section 2-201; the importance of the distinction between a merchant and non merchant under Article 2; battle of the forms under Section 2-207; parol evidence under Section 2-202; recovery of attorneys’ fees as consequential damages under Section 2-607(5)(a); right to adequate assurance of performance under Section 2-609, and the failure of presupposed conditions under Section 2-615.

All of this is supplemented with all of the posts on Article 1 starting with the Purposes and Policies of the UCC as stated in Section 1-102, and the mandate to the courts to ‘liberally construe and apply’ the Code to further these policies.  The policies stated in Article 1 create a macro framework through which to process all of the Uniform Commercial Code.  These blend with the policies of a particular Article in the interpretation process. Supplemental rules of law under Section 1-103(b) is another section which allows facts to be uniquely applied to the supplemental area of law which applies to the case.  For those of you seeking to learn Article 2, it would be helpful to review the earlier posts on Article 1, followed by the Article 2 posts.  The more thorough your knowledge of Article 1, the better your foundation for everything that follows.

As we go forward with Article 2, several things should be stated.  First—and this is my opinion—sales transactions are the least formalized transactions under the Uniform Commercial Code.  By that I mean it is less likely that there will be a finalized, integrated document which has been formally executed than in any of the other Articles.  Sales transactions often involve a phone call, some correspondence, a shipping document and conduct which recognizes the existence of the contract.  As a result, terms supplied by the Code have greater significance.

Second, the Article 2 expectation is that in the event of a dispute the parties will work it out through negotiation.  This is a reflection of how these matters are handled in reality, and is reflected in the general structure and content of Article 2. Hence, comment 4 to Section 2-607, which deals with a buyer’s duty to notify a seller of a breach with respect to accepted goods states:

The notification which saves the buyer’s rights under this Article need only be such as informs the seller that the transaction is claimed to involve a breach, and thus opens the way for normal settlement through negotiation.

The ‘looseness’ of Article 2 in this regard is to be contrasted with the specificity of other Articles. Under Article 9, for example, you are more likely to find a definitive answer to a problem than you would under Article 2.  Secured lenders want certainty when enforcement of a secured obligation must take place.  Thus, the policy of certainty is expressed in the text of Article 9 and the policy of ‘keep the deal alive’ is expressed in the structure and text of Article 2.

            Third, the definitions of ‘contract’ and ‘agreement’ as defined under Article 1 have particular significance under Article 2.  This follows from the lack of formality referred to above.  Thus, course of performance, course of dealing and usage of trade need to be carefully examined in each instance to see how a particular concept might impact the contract.  As noted in an earlier post, a particular transaction may not involve a ‘course of performance’ or ‘course of dealing’ since parties may be dealing with one and other for the first time, and the contract may not call for ‘repeated occasions for performance’ with objectionable behavior.  However, virtually all sales transactions occur within some trade or industry which has its own rules and protocols.  Absent limiting contract provisions, these rules and protocols become part of the contract. Trade journals are a potential source of incredibly valuable information.

             Part 3 of Article 2 deals with General Obligations of the Parties:  Among other things, Part 3 supplies certain terms that the parties may not have included in their written agreement or writings.  For example, in certain circumstances parties to a contract can conclude a binding deal without have explicitly agreed on a price; the Code will supply a place of delivery if none has been stated; and where action is required by no timeline stated, the Code requires that action be taken within a ‘reasonable time’.  This ties into a Section 2-204(3) discussed in an earlier post:

A contract does not fail for indefiniteness if the parties intended a contract and there is a reasonably certain basis for giving an appropriate remedy.

Section 2-301 states the obligations of the buyer and seller in very general terms:

The obligation of the seller is to transfer and deliver and that of the buyer is to accept       and pay in accordance with the contract.

 The comment to Section 2-301 explains this as follows:

In order to determine what is in ‘accordance with the contract’ under this Article usage of trade, course of dealing and performance, and the general background of circumstances must be given due consideration in conjunction with the lay meaning of the words used to define the scope of the conditions and duties.

 Section 2-301 thus forms the foundation for going forward in litigation; implicitly emphasizes the importance of drafting; and explicitly recognizes ‘usage of trade, course of dealing and performance’ as critical elements in determining the terms and interpretation of a contract.  These concepts, the drafting style of Article 2, and the overall purposes and policies of the Code should be incorporated in the process of analyzing Article 2 transactions.

A Case for Setting Standards

            In our discussion of Article 1, it was noted that the Uniform Commercial Code embodies freedom of contract as an underlying principle.  Section 1-302 is a codification of this basic principle. Section 1-302(1a) states as follows:

(a)  Except as otherwise provided in subsection (b) or elsewhere in [the Uniform Commercial Code], the effect of provisions of [the Uniform Commercial Code] may be varied by agreement.

The limits of the abilities of the parties regarding freedom of contract, as well as some of the specific freedoms granted are noted in section 1-302(b)

(b) The obligations of good faith, diligence, reasonableness, and care prescribed by [the Uniform Commercial Code] may not be disclaimed by agreement. The parties, by agreement, may determine the standards by which the performance of those obligations is to be measured if those standards are not manifestly unreasonable.

            It is my belief that parties should set standards for good faith, diligence, reasonableness and care whenever contracts are being drafted. Setting these standards removes the question from the jury or the court as to the actual legal question and restricts inquiry to the question of whether or not the fact standards set by the parties have been met and whether or not the standards set are manifestly unreasonable.  An excellent example of the importance of setting standards can be found under Article 7 in connection with the storage of goods.

Section 7-204 deals with the duties of a warehouse to exercise care with respect to goods it has stored.  Subsection (a) to Section 7-204 states as follows:

A warehouse is liable for damages for loss of or injury to the goods caused by its failure to exercise care with regard to the goods that a reasonably careful person would exercise under similar circumstances. However, unless otherwise agreed, the warehouse is not liable for damages that could not have been avoided by the exercise of that care.

It is seen that the warehouse must exercise the level of care which a ‘reasonably careful person’ would exercise under similar circumstances.  This of course, is a standard and used frequently in many areas of law. 

            What is or is not consistent with the standard enunciated however, can be dramatically different than what one might reasonably believe would meet that standard.  This is illustrated in United States Borax and Chemical Company v. Blackhawk Warehousing and Leasing Company 586 S.W. 2d 248 (Ark. CA, 1979). Borax involved the storage of goods consisting of agricultural chemicals owned by U.S. Borax pursuant to a warehousing agreement between the parties. In early 1977 goods belonging to Borax were stolen from Blackhawk. The goods in question consisted of 288 five gallon cans of a product known as Cobex.  The court described the burglary as follows:

The burglars entered the building by ripping open one of the side panels. Then chemicals which had been stored next to the wall were pulled outside to allow entry into the building. After entry a padlock and chain were cut to allow a door to be opened. A forklift truck was "hot wired" since it was locked. Then it was used by burglars to move a sailboat blocking the path to appellant's stored chemicals. Other chemicals in the way were shoved aside, and the cans of appellant's stored chemicals were taken from the premises. The loss sustained by the plaintiff amounted to $23,658.28 and suit was brought for that amount.  at 833-834

Defendant was granted a directed verdict by the trial court, and Borax appealed, stating that defendant was negligent in not providing the following specific security measures:

(a) In failing to provide watchmen inside the facility;

(b) In failing to have any burglar alarms or similar systems installed in the warehouse;

(c) In failing to provide roving patrols outside of the building;

(d) In failing to place palletized storage directly against the inside wall at the point of access as was done against other walls to prohibit any attempt to enter from the outside;

(e) In failing to provide other adequate security measures which would have prevented the break-in and subsequent loss to the plaintiff;

(f) In failing to be put on notice that extra security measures were needed after a previous break-in occurred at the warehouse approximately 7 months before the loss was sustained by the plaintiff. at 836

            The court discussed the security procedures in effect in the context of general negligence standards.  In quoting Arkansas case law, the court states the question as follows:

The failure to do something which a person of ordinary prudence would do under the circumstances, or the doing of something that a person of ordinary prudence would not do under the circumstances.  at 836-837

The court  reversed the trial court’s decision concluding that the question of reasonable care should have gone to the jury. 

            As a result of the agreement between the parties, the determination of reasonable care was placed in the hands of the court.  This worked out favorably for Borax, but the warehouse could have avoided the whole problem by simply stating the security measures being taken; selecting standards which are not ‘manifestly unreasonable; and then proving that those standards were met.  I am not an expert in warehouse security procedures, but it is clear that the burglary in question required considerable effort to succeed.  It may be that the suggestions made by Borax have merit, but it may also be that Blackhawk had adequate security in place.  If Blackhawk had properly drafted the warehouse receipt, the problem could have been avoided.

            The same rationale applies to every written contract.  Parties who set the standards of conduct to govern their transaction eliminate the problems which Blackhawk Leasing had to deal with in the Borax case.  In presenting this approach to the other party, it should be emphasized that everyone benefits from the certainty of setting standards.

Banks, Merchants & Article 2

As discussed in the previous post, the characterization of a party as a merchant or non merchant has great significance under Article 2.  This brings us to a point where the cases add a unique flavor to an otherwise very clear definition.  These cases also illustrate the positive results that creativity can bring to the table.  Very early in these posts, the importance of utilizing the mandates of Section 1-103 in presenting creative arguments was emphasized. By way of review, and in the context of the case to be discussed, Section 1-103 directs the court to ‘liberally construe and apply the code’ and to do so in a manner which promotes the underlying purposes and policies of the Code:

(a) The Uniform Commercial Code must be liberally construed and applied to promote its underlying purposes and policies, which are: (1) to simplify, clarify, and modernize the law governing commercial transactions; (2) to permit the continued expansion of commercial practices through custom, usage, and agreement of the parties; and (3) to make uniform the law among the various jurisdictions.

As you view these creative applications of the definition of ‘merchant’, it is useful to see how many of these purposes and policies support the broad interpretation adopted by the courts. 

            The first case for consideration is National Microsales v. Chase Manhattan Bank  761 F. Supp. 304 (S.D.N.Y. 1991)   The facts are briefly as follows:

National Microsales Corporation was engaged in the business of buying and selling computer output microfilming equipment. Chase Manhattan entered into negotiations with National Microsales Corporation to sell some of its used Computer Output Microfilming equipment to NMC for resale. When Chase subsequently sold the equipment to a third party, NMC filed suit alleging breach of contract.

Chase moved for summary judgment dismissing NMC's complaint on the basis of the Statute of Frauds, alleging that the purported contract in question was over $500 and there was no writing as required by Section 2-201(1).

National Microsales Corporation also moved for summary judgment claiming the contract in question was covered by the ‘merchant exception’ contained in Section 2-201(2).  As you may recall, that section applies only to transactions ‘between merchants’; hence, for that section to apply, the court would have to conclude that the bank was a ‘merchant’ under Article 2.

In presenting its case, NMC noted that Chase sold $6.5 million worth of used COM equipment from 1987-1989, and further that there were established policies and procedures of Chase which had been adopted for the purchasing new equipment as well as other ‘fixed surplus assets’.

Chase's response was that it never purchased goods for resale and that Chase has no specialized knowledge concerning the goods which it buys for its own use. There was also testimony that Chase had no familiarity with the market for the equipment which it purchased, and that when it disposed of surplus goods, it generally sold them to resellers, rather than end users, and usually sold the equipment for less than fair market value.

The court found that Chase was in fact a ‘merchant for purposes of the UCC’.  As support, the court quoted the definition of ‘merchant in Section 2-104 and Official Comment 2 to Section 2-104 which states:

The special provisions as to merchants appear only in this Article and they are of three kinds. Sections 2-201(2), 2-205, 2-207 and 2-209 dealing with the statute of frauds, firm offers, confirmatory memoranda, and modification rest on normal business practices which are or ought to be typical of and familiar to any person in business. For purposes of these sections almost every person in business would, therefore, be deemed to be a "merchant" under the language "who . . . by his occupation holds himself out as having knowledge or skill peculiar to the practices . . . involved in the transaction . . ." since the practices involved in the transaction are non-specialized business practices such as answering mail.

In applying the definition of merchant and comment 2 above, the court stated: 

This comment implies that Chase's familiarity with the goods it purchases and sells is sufficient to establish that it is a merchant for the purposes of § 2-201… For Statute of Frauds purposes, the scope and extent of Chase's activities qualify it for merchant status under the UCC.  National Microsales at 307

            The extent of the Court’s holding on the merchant matter is unclear.  On the one hand, the court seems to attempt to limit is holding on the merchant question to the Statute of Frauds provision.  If that were the case however, the Court could have easily so stated without any discussion of ‘Chase’s familiarity with the goods it purchases and sells’.  The limited reading would be found in the fact that responding to mail is something everyone in business should do as clearly stated in the comment.  In mentioning the goods and familiarity of practices with those goods, the Court can easily be interpreted to be saying more.

            There are huge implications from holding that the bank is a ‘merchant with respect to goods of the kind’ for at this point, the warranty of merchantability kicks in, as well as a host of other merchant provisions, some of which have been stated in the last post.  There is a large potential exposure to the bank if it is classified as a ‘merchant under Article 2’, which can create great leverage in litigation.