STROOCK POSITIVE ENERGY Issue 4 April 2015 What’s Required in Requirements A requirements contract is an agreement Contracts between a buyer and a seller whereby the seller promises to sell to the buyer, and the buyer Requirements contracts are prevalent in various promises to purchase from the seller, all of a industries because they serve the purposes of buyer specific type of good that the buyer requires over and seller alike. In the last six months, the term of the contract.2 Requirements contracts requirements contracts in the amounts of hundreds differ from traditional contracts for the purchase of millions of dollars were entered into for the and sale of goods because they do not specify a supply of goods such as geospatial mapping specific quantity of goods to be purchased by the products for use by the U.S. intelligence buyer. community and the supply of mechanical parts for use by the U.S. Navy.1 Although requirements contracts are a valuable ALSO IN THIS ISSUE tool for certain businesses, they are not without their own set of unique risks and issues. This Update: Power Up in the Air (Part II): article focuses on some of the key elements that EPA Proposed Regulations for New and parties should consider when structuring a Existing Power Plants………………………7 requirements contract, and provides important pointers to parties that are considering entering into requirements contracts. 2 Although this article focuses on requirements contracts, a corollary contract exists, known as an output contract, in which a seller promises to sell and 1 See the following news links: a buyer promises to purchase, all of the output http://www.afcea.org/content/?q=node/13661; produced by the seller for a certain commodity http://www.huntingtonnews.net/98739; during the term of such output contract. The http://www.bizjournals.com/orlando/news/2014/10 jurisprudence that has developed around /24/harris-corp-awarded-770m-mapping-products- requirements contracts and the issues raised in this services.html. article generally applies equally to output contracts. • • • • , , , - .. .. .. POSITIVE ENERGY What is a requirements contract? business from a customer who promises to purchase from the seller all of the goods the buyer A key component of a traditional contract for requires at a price the seller has freely negotiated. the purchase and sale of goods is the parties’ The seller establishes for itself a reliable off taker for express agreement on the specific quantity of the its product. goods to be purchased. In contrast, requirements contracts leave open the quantity term, which Issues concerning Requirements Contracts instead is to be determined specifically by the good 1. Enforceability faith requirements of the buyer over the life of the contract. Thus, requirements contracts are better The enforceability of a requirements contract viewed as relational contracts, which are formed typically has been raised as an issue by a party over time, as the course of dealing between the wishing to be relieved of its obligations under such parties develops.3 a contract. Prior to enactment of the Uniform Commercial Code, the “unenforceability” Requirements contracts provide a buyer certain argument met with some success. A survey of case advantages because they mitigate the risk that the law demonstrates that some courts have been buyer’s estimates of its needs are inaccurate which skeptical as to the enforceability of requirements could result in the buyer purchasing too much or contracts on the grounds that such contracts lacked too little of the good in question. In a traditional adequate consideration and definiteness. A purchase and sale contract, if the buyer orders too fundamental principle of contract law is that a much of a good , the buyer remains obligated to contract must set forth definite terms which pay for and take delivery of the excess goods it 4 embody the intent of the parties. As courts have does not need, and, if the buyer orders an noted, “a court cannot enforce a contract unless it insufficient quantity of goods, it will not have is able to determine what in fact the parties have sufficient inventory to satisfy the demands of its 5 agreed to.” Because they lack a defined contract business. As a result, the buyer will be forced to quantity, requirements contracts can be viewed as either, in the case of an oversupply, sell excess failing this definiteness test. supply in the open market or, in the case of an insufficient supply, purchase additional goods in Courts also have questioned whether the open market – such as the spot market for oil requirements contracts were premised on sufficient or power. In each case, the buyer will be exposed consideration, given that the buyer agreed to buy to price risk and potential supply and demand all that he required of a certain commodity, but did constraints. Under a requirements contract, the not actually commit, nor was required, to buy buyer purchases only the quantity of goods that it anything at all. The buyer could end up not requires—no more, no less. The buyer is assured, requiring any of the good covered by the contract, subject to the performance of the seller, that it has and thus purchase nothing under the contract a steady supply of goods at a set price that has been without breaching its terms. mutually agreed upon by the parties. This Although the enforceability of requirements certainty permits buyers to operate more contracts may have been an issue under common efficiently. Requirements contracts also provide advantages to the seller. As requirements contracts 4 See Glen Banks, New York Contract Law, Vol. 28, are typically exclusive, the seller secures future §2:15 (“Few principles are better settled in the law of contracts than the requirement for definiteness.”) 3 See Joseph M. Perillo, Corbin on Contracts, Vol. 2, 5 See Matter of 166 Mamaroneck Ave. Corp. v. 151 E. §6.5, p. 241. Post Rd. Corp., 78 N.Y.2d 88, 91 (1991). POSITIVE ENERGY law, Section 2-306(1) of the Uniform Commercial the buyer is free under the terms of the Code expressly addressed this issue. Section 2- requirements contract to purchase the goods it 306(1) of the UCC states in pertinent part: requires from vendors other than the seller. What A term which measures the quantity by has the buyer agreed to under a requirements the output of the seller or the contract, if it has no obligation to purchase requirements of the buyer means such anything from the seller and is free to satisfy its actual output or requirements as may requirements from other vendors? occur in good faith, except that no quantity unreasonably disproportionate Although the buyer’s promise under a non- to any stated estimate or in the absence exclusive requirements contract could be viewed as of a stated to any normal or otherwise illusory, several cases have upheld requirements comparable prior output or requirements contracts that embodied non-exclusive may be tendered or demanded. arrangements. For example, in City of Louisville. v. In other words, a requirements contract will not Rockwell Manufacturing Co.,7 the parties agreed that be deemed invalid due to indefiniteness as the plaintiff would supply the City of Louisville with quantity term will be deemed to be the actual part of its requirements for parking meters, in an requirements of the buyer as may occur in good amount approximately equaling 7650 parking faith. meters. The City later argued that there was no In Section 2-306, comment 2, the drafters of the actual contract between the parties, and the UCC laid to rest the concerns expressed at agreement was merely an open ended offer by common law regarding the definiteness and basis plaintiff to supply the parking meters at a set price for consideration in requirements contracts: and time, without any commitment on the part of the City. [A] contract for output or requirements is not too indefinite since it is held to mean The Sixth Circuit rejected the City’s argument, the actual good faith output or stating that under the UCC, “requirements” is not requirements of the particular party. Nor too indefinite a term, because it is held to mean the does such a contract lack mutuality of obligation since, under this section, the actual good faith requirements of the City when party who will determine quantity is dealing according to commercial standards of required to operate his plan or conduct fairness. The Sixth Circuit further held that the his business in good faith and according use of the word “part” was not illusory or lacking to commercial standards of fair dealing in in mutuality, in light of both the estimate for 7650 the trade so that his output or requirements will approximate a parking meters and the full record including a reasonably foreseeable figure…6 fulsome agreement, evidencing the parties clear intent to contract.8 By contrast, other cases have Concepts of good faith and reasonable held that an arrangement that is not fully exclusive proportionality provide support for the results in an agreement that is not an enforceable enforceability of requirements contracts. requirements contract.9 2. Exclusivity The law, however, is not settled on whether a 7 th 482 F.2d 159 (6 Cir. 1973). 8 requirements contract would be found enforceable Id. 9 if it were a non-exclusive arrangement in which See cases which found the requirements contracts unenforceable, for e.g., Mid-South Packers, Inc. v. Shoney’s Inc., 761 F.2d 1117, 41 U.C.C. Rep. Serv. 6 U.C.C. §2-306. Comment 2. 38 (5th Cir. 1985) (decided based on an analysis of POSITIVE ENERGY Given the uncertainty regarding whether been held to be sufficient to create an enforceable requirements contracts may be non-exclusive, requirements contract, the parties to a requirements sellers should endeavor to enter into requirements contract should provide more specificity as to what contracts that obligate the buyer to purchase the they mean by the buyer’s “requirements”.