Article 1: Always Relevant

                               

As of this post, we have covered most of Article1 and Article 3, and close to half of Article 2.  I am very pleased with the growing views on the blog, and have received some encouraging emails from readers.  As I stated when the blog first opened, the primary goal is to teach the basic meaning of the text of the UCC. Periodically, as in the last post, I find a case which requires discussion, but even in that context, the primary focus is on the meaning of the text and how it fits in the overall flow of the UCC.

 As a law professor, I felt it important to begin each class with a review, and periodically, and I feel the same need as to the blog, not just for the readers, but for myself as well.  With the large number of new readers, and a lot of substantive text behind us, I wanted to do a brief review of Article 1 and its impact on the UCC. This is done in the hope that whenever you may encounter a UCC transaction at the drafting, litigation, or intermediate stage, you will be certain to process the transaction through Article1 in addition to the substantive Articles activated.

I believe that Article 1 is the most important Article under the Uniform Commercial Code for two primary reasons.  First, Article 1 applies to all transactions under the Code per Section 1-102. Therefore, regardless of where you are in the Code, Article 1 has impact, and the impact can be dramatic. The substantive Articles deal with the subject matter with the purview of each Article, however, the content of these Articles only presents part of the story, for in order to truly understand the meaning of any of the substantive provisions of the UCC, it is essential to have a thorough understanding of Article 1.

Second, Article 1 contains some of the most powerful and impactful provisions of the Code, provisions which bring light and special meaning to the language of a contract; create remarkable drafting opportunities; and contain the fundamental policies upon which the UCC is drafted:

(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. [Emphasis Added]

As stated in Section 1-103(a)(1)(2)(3),  the drafters of the Code direct that the UCC be ‘liberally construed and applied’ to promote these policies. An attorney who lines up legal arguments with an appropriate policy, coupled with the directives for liberal construction and application, has a great advantage in guiding the court to the desired result.

In addition to the stated policies, Section 1-103 contains one of the most powerful and important provisions of the Uniform Commercial Code:

Unless displaced by the particular provisions of the Uniform Commercial Code, the principles of law and equity, including the law merchant and the law relative to capacity to contract, principal and agent, estoppel, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, and other validating or invalidating cause supplement its provisions.  Section 1-103(b)

The net effect of Section 1-103(b) is to incorporate all ‘principles of law and equity’ which exist, ‘unless displaced by the particular provisions of the Uniform Commercial Code.'  So, if the Code doesn’t knock it out via a ‘particular provision’ the whole body of law involved will supplement the Uniform Commercial Code provisions.  It doesn’t get more powerful than that.       

A simple review of the supplemental principals of law stated illustrates the massive content available to attorneys who are involved in UCC transactions.  The general law of contracts, agency, estoppel, misrepresentation and fraud often are often intertwined in commercial transactions.  Understanding the applicability of any of these supplemental principles, and how to creatively utilize them gives an enormous advantage to someone so armed. 

The impact of Article 1 is dramatically illustrated in the case of In Re Invenux, Inc., 298 B.R. 442, 51 UCC Rep Serv 2d (Bkrtcy. D. Colo. 2003).  The trustee in bankruptcy was attacking the validity of a security agreement on the grounds that it did not adequately describe collateral as required by Section 9-203 The security agreement in question was very detailed in its composition, but did not include stock that was purportedly to be included.  Defendant’s position was that the contract—i.e.—the security agreement, was reformed between the original debtor and the secured party and therefore, stock was incorporated into the security agreement.

The question before the court was very significant for two reasons.  First, if the court did not find a reformation, the security agreement would have been invalid and the security interest unenforceable.  Second, if the court found a reformation, as it did, the result would in effect be concluding that the supplemental principles contained in Section 1-103(b) can override the substantive provisions of another Article.  Considering the incredibly broad scope of Section 1-103(b), the implications are enormous. In re Inveneux is not an aberration as regards the impact of Section 1-103(b) on the substantive articles of the Code, but illustrative of the powerful impact that section can have under the UCC.

I review Section 1-103(b) in connection with every case I review under the Code.  Regrettably, a very large number of commercial transactions involve fraud and misrepresentation.  It may also be that under the law of a particular substantive Article a result may appear to be inequitable. Section 1-103(b) supplements the totality of the Code with the law of equity.  Even if one does not win on such a theory, it forces the opposition to respond and creates doubt.

            Another reason Article 1 is so important is that it contains critical definitions which are applicable throughout the Code.  There are two definitions which are so important and powerful under the Code that they must be highlighted.  These are the definitions of ‘contract’ and ‘agreement.’ 

            To get a full picture of the concept of contracts under the UCC, one must move beyond the instinctive reactions that most of us have when we hear the word ‘contracts’ in connection with the Code, namely, Sales contracts.  The application of the word contract under the UCC embodies much more. It is not an exaggeration to say that it is the most important definition in the Code, certainly from an operative standpoint.  Breach of contract is the essence of all lawsuits under the UCC.  So in viewing the UCC and the word ‘contract,' one should envision the concept as one which permeates the UCC.  By way of illustration, contracts exist under the Code between: buyers and sellers [Article 2]; lessors and lessees [Article 2A]; makers and payees [Article3]; banks and customers [Article 4]; applicant and issuer [Article 5]; issuer and bailor [Article 7] debtor and secured party [Article 9].

            The foregoing contractual relationships are illustrative, not by any means exclusive.  In an earlier post, I suggested the benefits of a systematic approach to all UCC problems.  This creates a consistency of methodology, and the brain will adjust accordingly.  Once the facts are thoroughly understood and diagrammed, I suggest a very detailed analysis of contract and agreement. As you will see shortly, the elements of agreement dramatically impact the bottom line meaning of the contract. Once the analysis of ‘contract’ and ‘agreement’ are in place, Section 103(b) should be reviewed.

  The formal definition of contract is found under Section 1-201(b)(12):

“Contract means… the total legal obligation that results from the parties' agreement as determined by the Uniform Commercial Code as supplemented by any other applicable laws."

It is clear from the foregoing definition, that in order to determine the elements of a particular contract, one must first ascertain the parties’ agreement, defined as follows:

“Agreement” means the bargain of the parties in fact as found in their language or inferred from other circumstances, including course of performance, course of dealing or usage of trade as provided in Section 1-303.              Section 1-201(b)(3)

The language of the parties may be explicit, but what it is fascinating, is that what might appear to be very clear and precise language, or no language, can be literally transformed by the application of course of performance, course of dealing or usage of trade. Each is discussed in Section 1-303(a)(b)(c) respectively.

Course of performance requires, among other things, a contract with multiple occasions for performance and course of dealing requires previous transactions between the parties.  Neither may be present in any given situation.  Amidst this uncertainty there is one thing that can almost always be counted on to supply valuable information to any agreement under the Uniform Commercial Code: Trade Usage.  Commercial transactions take place within the context of an existing industry, 99 plus per cent of the time.  Within that industry, there is a manner of business so customary and fundamental to the industry, that it becomes part of the agreement between the parties, regardless of whether or not it is even discussed.   

Trade usage is defined under Section 1-303(a) as follows:

A "usage of trade" is any practice or method of dealing having such regularity of observance in a place, vocation, or trade as to justify an expectation that it will be observed with respect to the transaction in question….

The impact that trade usage can have in a case is dramatically illustrated in the case of   In Re: Cotton Yard Antitrust Litigation, 505 F.3d 274 (4^th Cir., 2007).  At issue was whether or not plaintiff purchasers of cotton and poly-cotton yarn were required to submit their antitrust case to arbitration via an arbitration provision which, according to defendants, was part of the contract as a result of the regular and customary use of arbitration in the textile industry as a means of resolving disputes.  

At issue on appeal was whether the district court’s ruling which excluded

arbitration for the antitrust claim was correct. The court of Appeals reversed the District Court on the arbitration ruling.  After discussing case law which recognized arbitration as the standard manner of resolving disputes in the industry, the court held that the arbitration provision was automatically part of the contract between the parties as a result of arbitration being a trade usage in the textile industry.  This was true regardless of the fact that it was never formally agreed to by the purchasers.  The court further found that a party’s knowledge of a trade usage, or lack thereof, is irrelevant, a result which is clearly consistent with the text of the statute.

            There are over 86,000 trade associations in the United States, each with its own rules and general codes of conduct.  I recently consulted on a case which had a trade association of six members, but nevertheless had clear cut rules on what was supposed to happen in the event goods supplied by members of the association turned out to be defective.  While these rules may not always be controlling, they are always relevant.

Another very important provision under Article 1 is Section 1-302, the Code’s freedom of contract provision. Subsection (a) allows parties to change the ‘effect’ of provisions under the UCC, while subsection (b) states that ‘the obligations of good faith, diligence, reasonableness and care may not be disclaimed.'  However, the section goes on to state ‘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.'

By setting standards for the performance of the items noted, the parties dramatically change the inquiry should the matter end up in litigation.  In a case where no standards are set, the court and/or jury will determine whether or not a particular standard has been met. If standards are set, the inquiry is substantially different.  In this instance, the inquiry is: Were the standards met?  Are the standards set ‘manifestly unreasonable?' If met, and not manifestly unreasonable, they will hold up.  The latter scenario gives the parties much greater control as to the outcome in court.

One of the stated underlying policies of the UCC is ‘uniformity of law among the various jurisdictions’ Section 1-103(a)(3).  The provision has been interpreted by many courts to include decisions from other states in a local jurisdiction.  Therefore, an attorney has the case decisions of 50 states as part of his or her arsenal.  Many attorneys simply do not know about Section 1-103(a)(3) and are a corresponding disadvantage in working with the Uniform Commercial Code.

Another critically important provision under Article 1 is Section 1-304 which states:

Every contract or duty within the Uniform Commercial Code imposes an obligation of good faith in its performance and enforcement.

Good faith is defined as:

…honesty in fact and the observance of reasonable commercial standards  of fair dealing.

Breach of the duty of good faith can have serious consequences. Although the comments to Section 1-304 state that no independent cause of action can be brought for a breach of the duty of good faith, there is case law to the contrary.  In fact, in the case of   In First Nat. Bank in Libby v. Twombly, 213 Mont. 66, 689 P.2d 1226 (Mont. 1984), the court stated:

"When the duty to exercise good faith is imposed by law rather than the contract itself… the breach of that duty is tortious. Therefore, punitive damages are recoverable if the Bank's conduct is sufficiently culpable." First National Bank in Libby at 1230.

Any litigant who can persuade the court to entertain a claim for punitive damages has enormous leverage.

            It is important to note that while the definition of ‘good faith’ quoted above is adopted in the majority of jurisdictions, it has not been adopted in all of them. For example, New York, Illinois and Missouri have not adopted the amended definition of good faith. The minority definition of good faith is ‘honesty in fact in the conduct or transaction’ concerned.  There is no requirement for commercial reasonableness, itself a matter of interesting interpretation.  As the comments to Section 1-304 state, the conduct being reviewed is not the commercial reasonableness of the actual conduct in the transaction, but the commercial ‘fairness’ of the conduct.

            In this regard, it is important to remember Section 1-301 which allows parties to transaction under the UCC to choose the law of any state as long as that state has a ‘reasonable relation’ to the transaction in question.  Individuals involved in multistate transactions should always check the law of the other jurisdiction prior to any drafting so that the law most favorable to the client can be drafted into the contract.  Although the Uniform Commercial Code is designed to be ‘uniform,' it is processed through each state legislature before adoption.  Often changes are made and sometimes they are significant.  In addition, the Code gives various alternatives to the states to adopt.  Section 2-318 dealing with third party beneficiaries of warranties offers a dramatic example and potential impact of the differences between the provisions which may be enacted in a particular states.

            The forgoing sections are illustrative of the impact that Article 1 can have under the Uniform Commercial Code.  Most of the provisions of Article 1 are covered in earlier posts for any readers who want to review the same.  The critical point however, is that if you are involved in UCC transactions—whether at the drafting stage, or litigation—it is essential to have a solid working knowledge of Article 1.  This will give you an enormous advantage in all dealings which you encounter under the UCC.

Article 1; supplementary principles of law' reformation of contract; description of collateral; good faith; freedom of contract; trade usage; course of dealing; course of performance; punitive damages; customer banking relationship.

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.

No Price?—No Problem

The Article 2 policy, to facilitate the deal, is nowhere more evident than Section 2-305, for that section allows a contract to be formed regardless of whether or not the parties have agreed on a price. This is a radical departure from Pre-Code law. This rule is contained in the first sentence of Section 2-305 which states as follows:

‘The parties if they so intend can conclude a contract for sale even though the price is not settled….’

On it's face, this would seem to conflict with Section 2-204(3) which also facilitates the formation of a contract where the parties intend to form a contract, provided there is a ‘reasonably certain basis for giving an appropriate remedy.'  Price is definitely essential in providing an ‘appropriate remedy.' This is provided in the open price situation as follows:

In such a case the price is a reasonable price at the time for delivery if

(a) nothing is said as to price; or

(b) the price is left to be agreed by the parties and they fail to agree; or

(c) the price is to be fixed in terms of some agreed market or other standard as set or recorded by a third person or agency and it is not so set or recorded.

            There are a couple of things to be noted in Section 2-305(1).  First, there must be requisite intent by both parties to the contract for the open price term to be valid.  Second, it is important to remember the full import of the definition of ‘agreement’ when trying to ascertain whether the parties ‘agreed’ to an open price term.  Such an agreement can arise by way of course of performance, course of dealing and usage of trade.

            There are situations where the parties agree that a seller or buyer must set a price.  In such a situation, the price must be fixed in good faith.

(2) A price to be fixed by the seller or by the buyer means a price for him to fix in good faith.

Once again, we see the concept of good faith figuring into the equation. If the parties are merchants, this requires ‘honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.'  Remember that this definition, unlike the definition of ‘good faith’ in Article 1 ties ‘reasonable commercial standards of fair dealing’ to whatever trade is involved.

            One might have difficulty imagining an ongoing business practice of entering into open price contracts.  However, when viewed in the context of a fluctuating market, an open price term makes perfect sense.  The petroleum industry offers an excellent example of an industry that has an ongoing practice of open pricing.  Litigation within that industry demonstrates some points raised in earlier posts.  For example, is the good faith standard based upon a subjective analysis or an objective analysis.  In fact, in Mathis v. Exxon Corp., 302 F.3d 448, 454-57 (5th Cir.2002), the Fifth Circuit interpreted Texas law on the question to involve both subjective and objective standard.

            Mathis involved a claim by Exxon dealers in Texas which was predicated on alleged bad faith pricing by Exxon regarding the cost of gasoline to its dealers. The dealers alleged that Exxon was attempting to drive them out of business by overcharging for the gasoline which the dealers were required to purchase under their agreement with Exxon. Under the terms of the agreement, Exxon was permitted to set the price for the gasoline to be purchased by the Exxon dealers. The court noted:

Texas law, which tracks the Uniform Commercial Code, implies a good faith component in any contract with an open price term.   Specifically,

[t]he parties if they so intend can conclude a contract for sale even though the price is not settled. In such a case the price is a reasonable price at the time of delivery. A price to be fixed by the seller or by the buyer means a price for him to fix in good faith.

Exxon contended that its pricing was proper inasmuch the price charged was within the range of its competitors pricing and therefore established the ‘commercial reasonableness’ requirement of good faith. The dealers’ contention was that even if the price set was within the range stated by Exxon, good faith required more. In essence, the dealers stated that if the ultimate purpose of Exxon was to drive the franchises out of business, this would violate the ‘honesty in fact’ portion of the good faith requirement.

            The Court discussed comment 3 to Section 2-305 in great detail, noting that in a ‘normal’ case the type of standard pricing used by Exxon would have satisfied the good faith requirement.  However, the court went on to state that a lack of subjective good faith, such as the one alleged by the dealers, would take the pricing of Exxon into the realm of bad faith.  Accordingly, the judgment of the district court in favor of the dealers was affirmed.

            In Tom-Lin Enterprises, Inc. v. Sunoco, Inc. (R&M), 349 F.3d 277 (6th Cir. 2003) the court concluded that Ohio law required the analysis of the question of good faith to be limited to the objective standard:

Thus, under Ohio law, to show that a merchant-seller lacks good faith in fixing a price pursuant to a contract with an open price term, it must be shown that the price was not fixed in a commercially reasonable manner and, moreover, that the pricing was commercially unjustifiable. These are two distinct issues, and both involve an objective analysis of the merchant-seller's conduct. at 280 [Emphasis the Court’s]

The Tom-Lin case is brought to your attention for several reasons.  First, to illustrate the differences between the interpretation of the good faith requirement under Section 2-305; second to remind you of the importance of understanding key UCC provisions of any state in which your client might be doing business.  To the extent the transactions involve multiple jurisdictions, a party can draft the law of the favorable jurisdiction to control, provided the requisite contact with the chosen state exists.  As the Mathis and Tom-Lin cases indicate, the differences can have a dramatic impact on the outcome.

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.

Events Impairing Performance: The Code Response

In the previous post we looked at situations where ‘reasonable grounds for insecurity’ concerning the other party’s performance have arisen, as well as action which can be taken in such a situation to ‘demand adequate assurance of performance.’ The first sentence of Section 2-609(1) notes in this regard  ‘A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired.' The impairment contemplated by Section 2-609 is the result of some behavior by one of the contracting parties.

            Section 2-615 also contemplates a situation where performance is not forthcoming; however, in this instance, the non performance is not caused by the behaviors of one of the parties to the transaction.  Rather, the non performance (or partial performance) contemplated by Section 2-615 is the result of some event which makes performance ‘impracticable.'  Section 2-615(1)(a) reads as follows:

Except so far as a seller may have assumed a greater obligation and subject to the preceding section on substituted performance:

(a) Delay in delivery or non-delivery in whole or in part by a seller who complies with paragraphs (b) and (c) is not a breach of his duty under a contract for sale if performance as agreed has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made or by compliance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid.

In order for the event to come within Section 2-615, it must be of such a nature that the non occurrence of that event was ‘a basic assumption on which the contract was made.' 

The other situation contemplated by Section 2-615 is where the party who is unable to perform is precluded from performance by ‘any applicable foreign or domestic governmental regulation.' As noted in the text, it is irrelevant if the regulation is later proved to be invalid.

            There are several things which should be noted in the initial discussion of Section 2-615..  First, Section 2-615 deals with a situation where performance has become ‘impracticable.'  This is not the same thing as ‘impossible.'  As noted in Official Comment 3 to Section 2-615, the word ‘impracticable’ was used ‘to call attention to the commercial character of the criterion chosen by this Article.'  Second, although the section is drafted as pertaining only to the seller, Official Comment 9 states in part that in certain situations ‘the reason of the present section may well apply and entitle the buyer to the exemption.' There is case law which supports that result.  Third, a dramatic price change is not within the purview of Section 2-615.  That stated, there must have been some event that caused the dramatic price change, and that is where the focus should be directed.

In order to avail oneself of Section 2-615(1) the party must comply with Sections 2-615(a)&(b). Section 2-615(b) is activated when the triggering event affects only part of a seller’s capacity to perform and requires an allocation of product by the seller:

Where the causes mentioned in paragraph (a) affect only a part of the seller's capacity to perform, he must allocate production and deliveries among his customers but may at his option include regular customers not then under contract as well as his own requirements in any manner which is fair and reasonable.

Note, upon activation of Section 2-615(1), the seller ‘at his option’ may include ‘regular customers not then under contract’, and may also include its own requirements for further manufacture. 

Any allocation must be done in a ‘fair and reasonable manner.'  Once again, we see an opportunity to draft what is, or is not, an allocation which is fair and reasonable, and if this is done, the inquiry will be limited to: were the called for standards of ‘fair and reasonable’ met; and if so, were these standards not ‘manifestly unreasonable’ per Section 1-302.  As will be demonstrated shortly, this is one of several creative drafting provisions that can pay big dividends in the event of litigation.

            Section 2-615(c) states the final requirement for Section 2-615(a) to be properly utilized:

The seller must notify the buyer seasonably that there will be delay or non-delivery and, when allocation is required under paragraph (b), of the estimated quota thus made available for the buyer.

The procedure required for the notice referred to is contained in Section 2-616(1)(a)(b)(2)(3).*

            The general freedom of contract principle contained in Section 1-302 is explicitly stated in the first sentence of Section 2-615(a) which states in relevant part as follows : Except so far as a seller may have assumed a greater obligation... The ‘greater obligation’ does not need to be stated as guarantee of delivery in a Section 2-615 situation.  The greater obligation can be created through a remedial provision.

             Gold Kist v Stokes 138 Ga. App. 482 (1976), 226 S.E.2d 268 involved an appeal from a summary judgment.  There were a number of evidentiary issues at the trial court which the appellate court required to be heard by a jury.  Another issue raised was the failure of the trial court to include the introductory language of Section 2-615 in its jury instruction as it relates to ‘seller assuming a greater obligation’.  The contract in the Gold Kist case had the following provision:

... [i]f the producer is unable to deliver the quantity contracted for solely because of reasons beyond his control, the measure of damages for failure to deliver is the difference between contract and market price on the day of breach.

In reversing the trial court, the appellate court found that under the noted provision, seller had ‘assumed a greater obligation’ via the damage provision, and that the failure of the jury instruction to include the introductory language of Section 2-615 as it pertained to the assumption of a greater obligation by the seller was error.

            The case graphically illustrates a point made throughout these posts. Proper drafting yields great results.   The remedial provision probably got very little notice by the seller during negotiations or one would assume the seller’s attorney would have objected to the provision.  As a result of inclusion in the contract, the remedial provision effectively overrode the result that would have occurred under Section 2-615.

           

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*(1) Where the buyer receives notification of a material or indefinite delay or an allocation justified under the preceding section he may by written notification to the seller as to any delivery concerned, and where the prospective deficiency substantially impairs the value of the whole contract under the provisions of this Article relating to breach of installment contracts (Section 2-612), then also as to the whole,

(a) terminate and thereby discharge any unexecuted portion of the contract; or

(b) modify the contract by agreeing to take his available quota in substitution.

       (2) If after receipt of such notification from the seller the buyer fails so to modify the contract within a reasonable time not exceeding thirty days the contract lapses with respect to any deliveries affected.

         (3) The provisions of this section may not be negated by agreement except in so far as the seller has assumed a greater obligation under the preceding sections.

Right to Adequate Assurance of Performance: Be Clear!

Section 2-609 contemplates a situation where either party to a sales contract has ‘reasonable grounds for insecurity’ regarding the other party’s performance, and the insecure party wants some evidence that the other party is willing and able to perform. Subsection (1) to Section 2-609 states as follows:  

The cases are clear that the determination of whether or not a party’s stated grounds for insecurity are reasonable is a question of fact. In this regard, I want to emphasize a point made repeatedly throughout these posts, and particularly in connection with the discussion of Section 1-302(b) which allows parties to an agreement to set standards for what is or is not ‘reasonable’, provided the standards set are not ‘manifestly unreasonable’.  If standards for ‘reasonableness’ are in fact stated, the inquiry will be limited to: were the called for standards met, and if so, were the standards ‘manifestly unreasonable’? If the standards are not manifestly unreasonable, and proven, inquiry ends. Parties to a contract, can if they choose, create provisions for what ‘reasonably constitutes’ insecurity which would frame the inquiry as stated.

A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return.

Although there are some cases which state that an oral demand for ‘adequate assurance of due performance’ is sufficient, the majority of cases follow the clear language of the statute which requires that the request for adequate assurances be in writing. Further, the cases are clear that the writing which purportedly seeks adequate assurances actually make it clear in the writing that such a demand is being made.  Mere objections as to performance do not meet the standard of a demand for proper performance which is required to gain the benefit of the provisions of the section. As discussed in the last post regarding Section 2-607(5)(a), the best way to insure that the requirements of a particular provision are complied with is to track the language of the statute.

In Alaska Pacific Trading Company v Eagon Forest Products 85 Wn App 354, 93 P 2d 41 (1997) one of the issues considered by the court was whether the purported demand for assurances was properly stated.  The case involved a sales contract by which ALPAC was to sell 15,000 cubic meters of logs to Eagon.  The lumber was to be shipped from Argentina to Korea.  Between the time of the execution of the contract in April of 1993 and time stated time for shipment, the market price for the lumber dropped significantly. Eagon became tentative about performing under the contract and ultimately, ALPAC came to the conclusion that Eagan was not going to accept the logs, and decided not to ship. In discussing whether or not a proper demand for adequate assurance of performance had been made by ALPAC, the court stated:          

Here, while Ahn [Eagon] had some idea that Kimura and ALPAC were concerned about the status of the contract, he did not understand that ALPAC would withhold performance as a result….If we were to hold that, in every case where a contract becomes less favorable for one party, general discussions between the parties can be considered requests for assurances, we would defeat the purpose of 2-609. That section requires a clear demand so that all parties are aware that, absent assurances, the demanding party will withhold performance. An ambiguous communication is not sufficient.   Eagon at 357

When merchants are involved, the determination of whether or not a particular performance was such as to properly give rise to insecurity will be determined by commercial standards:

          (2) Between merchants the reasonableness of grounds for insecurity and the adequacy of any                 assurance offered shall be determined according to commercial standards.

This is consistent with Article 2 in general and the drafters’ consistent direction to focus on what is going on in the commercial world, not simply the legalese involved.  As stated in comment 2 to Section 2-202:

[This section definitely rejects] the premise that the language used has the meaning attributable to such language by rules of construction existing in law rather than the meaning which arises out of the commercial context in which it was used;

This policy applies throughout Article 2 and, through the expanded definition of good faith, arguably throughout the Code.

         Once a proper demand for adequate assurance of performance has been made, the failure to provide that assurance is a repudiation of the contract:

 After receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract.  Section 2-609(4)

Section 2-609 provides parties with a remedial type course of action which is short of litigation, but clearly creates a situation where insecurities about performance are either effectively dealt with through adequate assurances of performance or repudiation occurs as a result of not providing those assurances.  Firms dealing in sales and leases of goods would be well advised to create a template for properly activating and utilizing Section 2-609.  This is in addition to drafting a contract provision which sets standards for ‘reasonable grounds for insecurity.'