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A manager's guide to quieting the fears of commercial insecurity.

Centuries ago, when you felt insecure in a commercial transaction, you took a hostage - a son, a daughter or a wife who could be sold into slavery if the contracting party did not perform as agreed. Although clearly an effective incentive for complete performance, this barbaric commercial custom is no longer tolerated, and other methods must be found to calm the nerves. Lenders find solace in the security afforded by a mortgage on real property that they have carefully evaluated. Sellers of goods who finance a purchaser's transaction find safety by properly filing their statutory financial statement. Mostly, however, everyday buyers and sellers fear that they have little or no protection against a potential breach.

The creators of the Uniform Commercial Code empathized with these unprotected contractors and drafted a provision that, if properly invoked, comforts the unassured and fearful: the right to adequate assurance of performance [U.C.C. [section]2-609].(1) Unfortunately, U.C.C. [section]2-609 has been frequently misunderstood and improperly activated. This article reviews and analyzes several recent court decisions that provide guidance for the sophisticated manager in the proper and effective use of [section]2-609 and furnishes the manager, who seeks assurance that the terms of a contract with a weak buyer or unsteady seller will be fulfilled, a practical checklist for complying with the statute.(2)

Background for U.C.C. [section]2-609

The drafters of the U.C.C. recognized what contractors intuitively understand: the essential purpose of a contractual bargain is the actual performance of the agreement, not merely a promise to perform the agreement, coupled with the right to win a lawsuit in the future.(3) In that spirit, they framed U.C.C. [section]2-609 to provide a mechanism for contracting parties to retain a sense of reliance and security that the promised contractual performance will be forthcoming when due.(4) Acknowledging that sellers need protection from having to manufacture, procure and/or deliver goods to a financially suspect buyer, and that buyers need protection from a seller whose deliveries have become uncertain, three basic defensive measures were adopted.(5)

1. The insecure party may suspend its own performance as well as any preparation for performance, with excuse for any resulting necessary delay, until the situation has been clarified.(6)

Suspension of performance under this provision is interpreted by the courts to mean the holding up of an unassured party's performance pending the outcome of that contracting party's proper demand for adequate assurance. This protection is similar in principle to several older commercial doctrines that permit a seller to stop performance and perfect a lien, as well as excuse a buyer from prepayment if the seller's actions manifest that he or she cannot or will not perform.(7) It is important to note at this point, however, that although the code gives the uncomfortable party seeking adequate assurance powers that potentially could be abused by those with malevolent intentions, those powers are tempered by the code's overriding requirement that all parties must act in good faith. Further, in the case of a merchant, the reasonable observance of commercial standards of fair dealing in the trade is also mandatory.

2. The insecure party may demand adequate assurance that the other party's performance will be forthcoming.(8)

Insecurity does not have to arise directly from the contract in question. Consequently, if a buyer who fails to make payment on an outstanding account with the seller, the seller has cause, even if the items involved have to do with separate contracts, to request adequate assurance on the present contract.(9)

3. The insecure party may treat the contract as breached if its reasonable grounds for insecurity are not cleared up within a reasonable time.

The failure of a party to provide adequate assurance of performance pursuant to a proper demand results in a breach of contract by repudiation under the code. The 30-day statutory limit on the time allowed to provide adequate assurance was placed in the statute to eliminate the issue of reasonableness in future litigation between the parties.(10)

Case Study

With that basic statutory information before us, let's look at a typical contractual problem between a buyer and its unsteady supplier.

Langer Supplies agrees to provide Soto Construction with all of the roof trusses Soto may require during the calendar year, and Soto agrees to buy only from Langer. Soto orders 100 trusses and receives 85 during the month of January. In February, Soto orders 110 and receives 90. Soto accepts the smaller shipments because it needs the trusses to meet its construction deadlines. Despite Soto's complaints, Langer does not meet the quantity requirements requested by Soto. Langer tells Soto not to worry - that the firm will "...make it up as the year goes on..." Soto wants Langer to complete the contract because its quality and price are good. However, if it cannot obtain the quantities it requested, Soto would like to find a new supplier without the fear of liability.

These facts would make any buyer uncomfortable. Clearly, Soto wants assurances from Langer, but how does the firm go about getting them? If the firm does not get the assurances it needs, how can Soto terminate the contract with Langer and insulate itself from a claim for damages? In other words, can Soto find some comfort and protection under U.C.C. [section]2-609?

After setting the premise that all contracts for the sale of goods impose "...an obligation on each party that the other's expectation of receiving due performance will not be impaired,"(11) U.C.C. [section]2-609 sets forth a relatively clear procedure for Soto to follow: Determine if reasonable grounds for insecurity concerning the performance of the contract are present.(12)

Soto's uneasiness just rose several degrees. What are reasonable grounds? Not surprising, what is reasonable for one party or type of transaction may not be reasonable for another. Among merchants like Soto and Langer, reasonable grounds are determined by the commercial standards in their industry rather than arbitrary legal standards.(13) A recent case gives support to and serves as an excellent example for Soto:

A company is contracted to blend, label, and package quart plastic bottles of motor oil for an oil company. It fails to provide the quantity and quality of bottles required under the contract. As in our hypothetical case, the oil company has, arguably, sufficient grounds for cancellation of the contract. The oil company, however, does not cancel and, consequently, loses its right to do so. The court held that the actions of the supplier constituted sufficient grounds for the oil company to feel discomforted and to have the right to receive adequate assurance under [section]2-609.(14)

Other Grounds For Concern

Although both our example and the case study have the offending party delivering defective or fewer than contracted goods to the buyer who subsequently demands adequate assurance, the defective delivery of a product does not necessarily have to exist for the buyer to have reasonable grounds for insecurity and, therefore, be able to activate [section]2-609. A buyer who discovers that the seller is making defective deliveries to other buyers with similar requirements has grounds to request adequate assurance under the statute.(15) Over the years, many other types of activities consistently have been found by the courts to constitute reasonable grounds for insecurity, including:

* The other party has failed to perform other transactions or contracts

* The other party is making excessive use of credit

* Reports from a trustworthy source that the seller has shipped, or is planning to ship, defective goods

* Rumors about the other party's instability have circulated in the industry

Clearly, Langer has failed to perform appropriately under its contract with Soto. Even though Soto has probably lost its right to cancel the contract,(16) Soto has a powerful argument that Langer's actions have made it insecure enough to be entitled to receive adequate assurance from Langer. Unquestionably, as a result of Langer's defective deliveries during the last several months, Soto has reasonable grounds to feel insecure that the remainder of the contract will be performed in a proper and timely manner. The statute and current case law support Soto's position. Perhaps Langer is having other problems. A discreet credit/business check by Soto may turn up further information to buttress its position. The first major obstacle faced by Soto has been successfully passed.

Appropriate Next Steps

Demand, in writing, from the other party adequate assurance of due performance.

The writing requirement, although seemingly the easiest to fulfill, is the one most frequently violated by unwitting purchasers and suppliers. For myriad reasons, many apparently related to the fear that a strongly-worded demand for adequate assurance will precipitate the feared breach or engender bad feelings from an otherwise acceptable purchaser or supplier, the insecure party will not send a written demand. If a written demand is sent, it often will be unclear or not forceful enough in its call for adequate assurance. Although the U.C.C. calls for the writing requirement to be liberally construed (i.e., no "major formula"), the courts generally have held that mere verbal requests for adequate assurance are, as a rule, inadequate.(17) Many cases have been lost because there was no written demand whatsoever, or the writing demanding adequate assurance was vague, weak, or unclear. Equivocal behavior in this territory can be deadly when the dispute inevitably ends up in court. The following recent case serves as good counsel for Soto as well as a sad reminder to contractors who do not prepare a timely and proper written demand.

A seller of wheat ceased performance under a purchase contract because he received reliable and reasonable information that the buyer was having financial setbacks and might not be able to pay. The seller advised the buyer that it had information that the buyer had been paid by his buyers and had not paid other sellers. The seller orally demanded assurances. The buyer pointed out that the payment terms required shipment in full before payment was due and requested that the seller resume performance. Two weeks after suspending performance, the seller made a written demand for assurances of performance that the buyer would pay under the contract. The court held that the written demand was too late and that the oral demand was inadequate as to form and content to satisfy even a lenient interpretation of [section]2-609.(18)

To prevail, Soto must be careful not to let time slip away and, therefore, place itself in the same position as the wheat seller. Verbal demands are useful, but Soto must not forget that they should be followed promptly by a proper written demand for adequate assurance.

Demand a method of adequate assurance that is reasonable under commercial standards.

The method requested for the provision of adequate assurance must be reasonable, when measured by commercial standards. Again, Soto must be troubled as it thinks: reasonable - that's a lawyer's word which can mean almost anything. This time, however, Soto has some guidance. The adequacy of the assurance is not measured solely by whether the insecure demanding party is satisfied with the assurances provided. Rather, the assurances will be measured by whether reasonable commercial actors in the industry would find the assurances sufficient in light of the particular fact pattern. In other words, Soto is not the metaphoric ultimate arbiter of good taste. As the party requesting assurance, Soto must exercise good faith and observe reasonable commercial standards in its demand.

The method of assurance demanded may vary from a mere reaffirmation of the party's intent to perform to the posting of a surety bond. For example, if Soto can use the defective delivery, a respected seller's promise that the defect will not be repeated will generally be sufficient. On the other hand, if Soto cannot use the defective goods, the seller's assurances must include replacement, repair, money allowance or another commercially acceptable cure.(19) Not surprising, it depends upon the company with which you are contracting and the particular circumstances of the transaction, e.g., a mere affirmation from IBM may be sufficient, but the same promises from your local supplier may not. The court, in the previous oil company example, provided a clear translation for Soto to follow: "...continual excuses for failing to perform, unaccompanied by corresponding remedial action, cannot be deemed adequate assurance under the Code."(20)

So, what is Soto to do? The problem of what form of assurance Soto should request is complicated but solvable. A mere affirmation by Langer of intent to perform is not going to allow Soto an uninterrupted night of sleep. Perhaps Soto could demand that all orders be brought up to date by a certain date; demand to see the material orders to Langer's suppliers for the Soto job; demand to be permitted to inspect the material and that it be set aside and designated by Langer for the Soto job; have all completed trusses clearly designated for its project; and require Langer's unequivocal written affirmation that all future orders will be filled in a timely and proper fashion according to the contract. Requiring the posting of a bond, in this case, may be viewed as overreaching and, subsequently, open to the charge that the demand was unreasonable.

Contents of Written Demand

Recent cases, in which the demand for adequate assurance was found to be valid and enforceable, present unambiguous guidance for making a proper request for adequate assurance of performance. Upon review, a clear message emerges from these cases: There should always be a written demand and the writing must clearly and unequivocally demand and outline a commercially reasonable method of providing the requested adequate assurance. Consequently, the written demand, at a minimum, should state clearly:

* It is a demand for adequate assurance pursuant to U.C.C. [section]2-609 or the appropriate state statute

* The commercially reasonable method that the offending party must use to assure the requesting party of its performance

* A date, not later than 30 days from the date of the demand, for compliance

* If you believe it is necessary, you will suspend performance of your contractual obligations until the adequate assurance required is provided

* If they do not provide the adequateassurance required, their failure will constitute a repudiation of the contract, and you will seek remedy.

Clearly, purchasers and suppliers alike can be comforted by the knowledge that adequate assurance of performance may be available to those who follow the statutory prescription. Relief and a good night's sleep may be just a strong letter away!

1 U.C.C. [section]2-609 provides: (1) 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. (2) Between merchants, the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards. (3) Acceptance of any improper delivery or payment does not prejudice the aggrieved party's right to demand adequate assurance of future performance. (4) After receipt of a justified demand failure to provide within a reasonable time, not exceeding 30 days, such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract. See also, U.C.C. [section]2A-401, where a similar provision is applied to the performance of lease contracts.

2 The concept of adequate assurance can be found in international transactions as well. The Convention on Contracts for the International Sales of Goods [CISG] contains a provision, Article 71, which states: (3) A party suspending performance, whether before or after dispatch of the goods, must immediately give notice of the suspension to the other party and must continue with performance if the other party provides adequate assurance of his performance. A similar remedy, known as the Nachfrist Notice, is found in the civil law tradition.

3 U.C.C. [section]2-609, Official Comments [paragraph] 1.

4 Ibid.

5 U.C.C. [section]2-609, Official Comments [paragraph] 2.

6 Ibid.

7 Ibid.

8 U.C.C. [section]2-609 (2)

9 U.C.C. [section]2-609, Official Comments [paragraph] 3.

10 U.C.C. [section]2-609, Official Comments [paragraph] 5.

11 U.C.C. [section]2-609 (1).

12 Ibid.

13 U.C.C. [section]2-609 (2).

14 LNS Investment Company, Inc. v. Phillips 66 Company, 731 F.Supp. 1484, 1488 (D.Kan. 1990).

15 U.C.C. [section]2-609, Official Comments [paragraph] 3.

16 Fortunately for Soto, the U.C.C. even forgives Soto's acceptance of Langer's previous inadequate or improper deliveries. Despite its acceptance of Langer's previous deliveries, Soto retains its rights under the U.C.C. to demand adequate assurance of future performance. U.C.C. [section]2-609 (3).

17 See, National Ropes, Inc. v. National Diving Service, Inc., 513 F. 2d 53 (5th Cir. 1975); Automated Energy Systems, Inc. v. Fibers and Fabrics of Georgia, Inc., 164 Ga. App. 772, 298 S.E. 2d 328 (1982). Contra, ARB, Inc. V. E-Systems, Inc., 663 F.2d 189 (D.C.Cir. 1980).

18 Scott v. Crown, 765 P.2d 1043 (Colo.App. 1988).

19 U.C.C. [section]2-609, Official Comments [paragraph] 4.

20 Supra, note 14.

RENE SACASAS, J.D., is chairman of the Department of Business Law at the University of Miami in Coral Gables, Florida. His research has appeared in many national law and business journals including Baylor Law Review, The Banking Law Journal, Transportation Law Journal, Dequesne Law Review, The CPA Journal, and BUSINESS FORUM. Professor Sacasas' teaching and research interests include the legal aspects of international finance, real estate development, transportation regulation and lawyer/management relations. He has been named to Leadership Florida and Who's Who in American Law.
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