Exiting Unfavorable Contracts
We work with someone that designs, manufactures and distributes certain goods internationally. Under prior management, they entered into an unfavorable contract granting to a particular company exclusive distribution rights in a very lucrative foreign territory. There was no minimum sales requirement. The contract also stated that it could be terminated only upon the mutual agreement of the parties. Things worked well enough for several years, but then sales dropped dramatically. Most recently, for a period of about 18 months, there were no sales whatsoever. Our client was not selling any goods in the lucrative foreign territory. Our client asked the distributor to end the contract, but the distributor refused. Several lawyers told our client they were stuck with the contract. The situation was infuriating.
One option was to catch the distributor in a breach of contract serious enough to warrant termination of the contract. But not every breach of contract is sufficiently material so as to justify termination. Contracts often contain many small promises. For example, I may hire you to paint my house, and you promise to give me 24 hours prior notice of when you will begin. Instead, you give me 22 hours’ notice, and you then paint the house. Most judges will not find that breach of contract sufficiently material to justify terminating the contract.
In our case, we examined everything the distributor had done, and also had an accounting audit done. We found a number of minor breaches, but nothing sufficient to terminate the contract. We needed more.
Research led us to the Uniform Commercial Code (“UCC”), a statute that governs commercial transactions. Virtually every state has a UCC, often with some local variations. In New York, UCC Section 2-609 contained very appropriate and useful provisions. Here is the entire section:
- 2-609 Right to Adequate Assurance of Performance
(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 thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract.
To interpret, if the buyer stops purchasing, the seller may justifiably feel insecure about the ability or willingness of the buyer to continue to perform the contract. The seller is therefore entitled to demand adequate assurance that the buyer will perform. The buyer has 30 days to respond to the demand. If the buyer does not provide adequate assurance within that time, then the buyer is deemed to have repudiated the contract, which gives rise to the seller having a right to remedies which include cancellation of the contract (this remedy is found at UCC §2-703(f)).
UCC §2-609 comes with official notes which are intended to explain the purpose of the law. The relevant part says:
- The section rests on the recognition of the fact that the essential purpose of a contract between commercial men is actual performance and they do not bargain merely for a promise, or for a promise plus the right to win a law suit and that a continuing sense of reliance and security that the promised performance will be forthcoming when due, is an important feature of the bargain. If either the willingness or the ability of a party to perform declines materially between the time of contracting and the time for performance, the other party is threatened with the loss of a substantial part of what he has bargained for. A seller needs protection not merely against having to deliver on credit to a shaky buyer, but also against having to procure and manufacture the goods, perhaps turning down other customers. Once he has been given reason to believe that the buyer’s performance has become uncertain, it is an undue hardship to force him to continue his own performance. Similarly, a buyer who believes that the seller’s deliveries have become uncertain cannot safely wait for the due date of performance when he has been buying to assure himself of materials for his current manufacturing or to replenish his stock of merchandise.
Given this legal ammunition, we wrote a letter to the distributor asking for their assurances within 30 days that they would resume meaningful purchases, and thereafter, would actually resume meaningful purchases. Without such assurances, we said, we would go to court to show that they had abandoned the contract and we were entitled to cancellation. We also provided the sales history to demonstrate the abandonment. We also offered that we would be willing to settle our dispute by voluntarily and mutually terminating the contract.
The distributor contacted us within the 30 day period and informed us that they chose voluntary termination. We drafted a termination agreement which tied up a few loose ends, such as requiring them to remove our client’s name and logos from their marketing materials, and the disposition of inventory still in their possession. With the agreement signed, our client was then free to engage other distributors in the territory, and lived happily ever after.
Business owners who believe they are stuck in unfavorable contracts should consider consulting with experienced business attorneys.