A Supplier's Guide to Requirements Contracts
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Long-term requirements contracts are a way of life for manufactures in supply chain driven markets particularly in the aerospace, transportation, and agricultural industries. These markets, which often involve complex production cycles and numerous contracting parties, are full of upstream component suppliers regularly locking-in their middle-link buyers over the long term with promises of lower prices and economies of scale. Middle-link buyers stand on firm contracting ground as well; they freely negotiate on price generally because the can send their suppliers attractive volumes over the long term. And the Original Equipment Manufacturers, positioned at the end of the buying spectrum, who are generally responsible for creating the upstream orders, get the benefit of a relatively cost effective product received according to their specifications, so that they too may keep their customers coming back for more.
Suppliers should know, however, about the uncertainty in the law governing these seemingly beneficial agreements. What happens when your buyer intentionally reduces its requirements to zero? What happens when the market dries-up, or when buyers simply want to replace suppliers with lower cost alternatives regardless of motive? Given this uncertainty, we offer practical tips for how manufacturing suppliers may protect themselves in negotiating long-term requirements contracts.
The Uniform Commercial Code Section 2-306 governs requirements contracts. The statute provides in relevant part that:
[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.
On its face, application of the statute seems relatively straightforward. Buyers must place their orders for amounts determined in good faith or in close proximity to a stated estimate if one exists in the requirements agreement.
In practice, however, this simplicity is elusive. Courts around the country have applied the statute in several distinct ways. Some, as in Simcala, Inc. v. Am. Coal Trade, Inc., 821 So.2d 197 (Ala. 2001), follow the plain meaning rule. Under the plain meaning rule, a stated estimate in the parties' requirements contract is a center around which a court should measure buyer variations. That is, it does not matter whether the buyer's purchases were reduced in good or bad faith, including legitimate business reasons. What matters is the bargained for stated estimate in the parties' agreement and whether buyer reductions are reasonably proportionate to it. Courts following this approach rely heavily on stated estimates, viewing them as a reflection of the parties' intent over expected purchases.
A different approach is embodied in the reasoning of Judge Posner's decision in Empire Gas Corp. v. American Bakeries Co., 840 F.2d 1333 (7th Cir. 1988). There, the Seventh Circuit ruled that stated estimates have different meanings with respect to increases and decreases in buyer requirements. The standard of reasonable proportionality governs increases, and the mercurial standard of good faith governs decreases. Posner's interpretation, followed by a majority of courts, poses problems for sellers relying too much on existing market conditions, or their stated estimates, because courts have ruled that decreases in production, changes in technology, and the emergence of generic product alternatives, are all good faith reasons for buyers to reduce their requirements.
What can suppliers do to protect themselves against losses caused by a reduction to zero, or near zero? Consider the following tips:
1. Have a Stated Estimate
Having a stated estimate in your contract is smart regardless of the state of the law. If the court interprets Section 2-306 according to its plain meaning, a stated estimate will mark the center around which reasonably proportionate variations should occur. If, the court adopts the Empire Gas model, a stated estimate should nevertheless serve as an indication of party intent, and a starting point to compare buyer reductions. While your buyer may attempt to argue that the reduction was for a valid business reason, the court will have a reference point from which to measure that reduction, together with the size and reasons for it.
2. Include a "Notice of Requirements Reduction" Provision
Why not include a notice provision in your agreement? As practical matter, buyer notice could give suppliers sufficient warning to at least minimize loss and look for other opportunities. Calculate the amount of time your business needs to prepare for a drop in estimated requirements; consider using your lead time. If you receive notice of an anticipated drop in demand that is equivalent to or greater than this time, then you may halt production and prevent overinvestment in the contract. Moreover, the inclusion of a notice provision will arguably function as another measure of buyer good faith.
3. Be Explicit: Write a Contract that Addresses Anticipated Problems
A seller can explicitly account for problem situations in the contract. For example, if it appears likely that a generic lower-cost alternative product is coming down the pike, then contract for this specific situation. Consider language that obligates your buyer to still buy your more expensive, non-generic, product. Think ahead, be as specific as possible, and leave as few outs as you can in your agreement.
4. Know Your Buyer, and Adjust Your Contract Accordingly
Requirements contracts work best between sophisticated parties likely to have an ongoing business relationship. These parties have an incentive to put forth their best efforts and maintain a good reputation within their industry. In a context where parties interact frequently, it is less likely that buyers will reduce their requirements to zero without an actual legitimate business reason. Given the fact that sellers take on the risk of market fluctuations, at least under a good faith standard, it is imperative that the supplier trust the buyer. If the buyer is unfamiliar to the supplier, or an infrequent business partner, it is perhaps better to choose a less uncertain form of agreement by shifting risk of market fluctuation to the buyer, or contracting for guaranteed minimum purchases.