Previous articles in the Supply Chain Survival Series have discussed a number of topics, including how contracts are formed and modified, and what default terms may be deemed to be part of an agreement under the UCC Battle of the Forms. This article will explore the protections that parties have in the event that things go wrong (or look like they might go wrong) under the UCC: anticipatory repudiation and adequate assurance of future performance.
Six months ago, you signed a contract committing ABC Corp. to purchase all of the widgets it needs to manufacture its products from XYZ Corp. In this contract, XYZ Corp. committed to supply all of ABC Corp.’s widgets for five years. While reading the news this morning, however, you saw that XYZ Corp. has announced it is shutting down its business division responsible for manufacturing these widgets. You need those widgets to manufacture your products, and so you immediately start to wonder: what are my options? Despite the long-term contract, can you immediately start purchasing the widgets from another supplier? Or do you have to keep purchasing from XYZ Corp. until they actually stop shipping to you? You once again reach out to your lawyer, who explains that the answer lies in whether XYZ Corp.’s announcement creates reasonable grounds for insecurity regarding XYZ Corp’s continued ability and intention to perform the contract, and whether the announcement constitutes an anticipatory repudiation of the contract.
Anticipatory Repudiation
Anticipatory repudiation of an agreement occurs when a party to that agreement, through words or actions, indicates that it will refuse or be unable to fulfill its future obligations under the agreement. Anticipatory repudiation of an agreement can occur through specific written or oral communication or it can be implied from a party’s actions.
There is a two-pronged test to determine whether an anticipatory repudiation has occurred. First, the communication or action must either (1) overtly communicate a party’s intention not to perform an obligation under the agreement, (2) render performance of an obligation reasonably impossible, or (3) demonstrate a party’s clear determination not to continue to perform an obligation when performance will be due.1 Second, a failure of a party to perform the contractual obligation must substantially impair the value of the contract to the other (non-breaching) party.2
Determining whether a party’s failure to perform substantially impairs the value of the contract is a highly fact-specific analysis. Impairment of a contract’s total value can be related to the quality of the purchased goods, the quantity of the purchased goods, the timing of delivery of the purchased goods, or the assortment of the purchased goods. The drafters of the UCC included a note that, in their view, the most useful test to determine whether substantial impairment exists is whether the aggrieved party would suffer a material inconvenience or injustice if it was required to wait and see whether the other party performs its obligations in full.3
Some common examples of anticipatory repudiation include:
- A seller provides an unequivocal communication that goods will not be delivered unless a buyer agrees to a price increase.
- A seller indicates that it will halt production of goods that it is contractually obligated to supply (for instance, because a manufacturing facility has been shut down, a business division has been shuttered, etc.).
- A buyer states that it will not pay for previously ordered goods as required by a contract.
- A seller obtains credible information regarding a buyer’s material adverse change in credit rating or diminishing financial condition (but only if such information would result in a buyer’s inability to timely perform under an agreement).
- A party makes an inappropriate demand for adequate assurance and indicates that it will suspend its performance under the contract (discussed further below).
Responses to Anticipatory Repudiation
Aggrieved Parties
Returning to our example above, because XYZ Corp. made it clear that they would no longer be producing widgets, and because XYZ Corp.’s failure to produce widgets would substantially impair the value of the contract to ABC Corp., it is likely that XYZ Corp.’s announcement of the division shutdown constitutes an anticipatory repudiation of the agreement. Under the UCC, ABC Corp. now has the option of (1) waiting a commercially reasonable time for XYZ Corp. to retract the repudiation and perform its obligations under the agreement, (2) sending a formal demand for adequate assurance, as discussed below, (3) treating the agreement as being breached by XYZ Corp. and pursuing any available remedies, or (4) notifying XYZ Corp. that it is treating the agreement as cancelled and the notice of repudiation as being final.4 Regardless of which option ABC Corp. elects to pursue, it may also suspend its own performance under the contract if such suspension of performance is commercially reasonable under the circumstances.5
While ABC Corp. may decide to wait and see if XYZ Corp. retracts its repudiation before pursuing a breach of contract claim, it needs to be careful not to wait longer than a “commercially reasonable” period of time. By waiting longer than a commercially reasonable amount of time, ABC Corp. will be prevented from recovering damages that should have been avoided by acting on the repudiation earlier.6 And, importantly, ABC Corp. may not rely on the remedies discussed in this section if it itself is in breach of the underlying agreement.
Repudiating Parties
XYZ Corp. can retract its repudiation prior to the time its obligation is due under the agreement unless (1) ABC Corp. has materially changed its position in reliance of the repudiation (e.g., ABC Corp. has already signed a contract with an alternative supplier for the goods covered by the repudiated contract) or (2) ABC Corp. has communicated to XYZ Corp. that it has treated the agreement as cancelled or the notice of repudiation as being final.7 If the repudiation is retracted, the contract will be reinstated and all rights and obligations of the parties under the contract will remain in place, except that allowances will be made to ABC Corp. for any delay in its performance caused by XYZ Corp.’s repudiation.
If a party wishes to retract its repudiation of a contract, it should communicate the retraction promptly and clearly, indicating that it will unequivocally meet its performance obligations under the agreement. Although not required, it is best practice to indicate an intent to retract a repudiation of a contract in writing so that there is a clear record of the retraction.
Demands for Adequate Assurance
Sometimes, a party may learn of circumstances that, while not rising to the level of an anticipatory repudiation of a contract, raise reasonable doubts that the other party will perform their obligations under the contract. Returning to our example above, imagine that XYZ Corp. learns from a mutual supplier that ABC Corp. is close to insolvency and has stopped paying its bills. These rumors are further substantiated by XYZ Corp.’s own experience with ABC Corp., who is late to pay XYZ Corp. for the most recent shipment of widgets. Is XYZ Corp. still obligated to ship widgets to ABC Corp. even though it has a reasonable belief that ABC Corp. will not pay for those widgets? Section 2-609 of the UCC provides a mechanism to address this situation through a demand for adequate assurance of performance.
If reasonable grounds for doubt (or “insecurity”) exist that a party will perform its contractual obligations, the other party may issue a written demand for adequate assurance of due performance and (if commercially reasonable) suspend its own performance under the agreement until such assurance has been provided.8 There is, however, considerable risk in suspending performance when making a demand for adequate assurance, because, by suspending performance, a party risks being in breach of the contract if a court later determines that it did not actually have reasonable grounds for insecurity. Thus, it is common to make a demand for adequate assurance and allow a reasonable amount of time for the other party to respond before suspending performance.
In an agreement between merchants, when determining the “reasonableness” of grounds for insecurity and the “adequacy” of assurances provided, a commercial standard is used.9 While the UCC does not provide specific guidance about what constitutes reasonable grounds for insecurity, courts have held that there must be a factual basis that forms the reasonable belief that a party is insecure – a party cannot merely suspect that the other will breach the agreement.10 These facts do not need to be directly related to the performance of the agreement. For instance, a deterioration of a party’s financial condition or credit rating may create reasonable grounds for insecurity if it is reasonable to conclude that such deterioration could result in that party’s failure to perform its obligations under the agreement.11
If XYZ Corp. wants to make a demand for adequate assurance from ABC Corp., the UCC requires that the demand be made in writing. Letters containing a demand for adequate assurance should explicitly state that the letter contains a demand for adequate assurance under Section 2-609 of the UCC (as adopted in the relevant state). The demand letter should also state the basis of the writer’s believe that reasonable grounds for insecurity exist, indicate what assurance is being requested and state when the assurance should be provided.
XYZ Corp. should carefully tailor its demand letter so that the request for adequate assurances is limited to the performance previously bargained for in the contract (i.e., payment of goods). If a demanding party requests that a contract be modified or suggests that it will not perform its own obligations under a contract until the contract has been modified, it may be construed as an improper demand for adequate assurance. For instance, while XYZ Corp. could require that ABC Corp. provide a letter of credit to secure its performance under the agreement, it cannot demand that ABC Corp. agree to new terms of payment or higher prices of goods. An improper demand from XYZ Corp. might itself constitute an anticipatory repudiation of the contract, giving ABC Corp. rights and remedies under the UCC.
Once a demand for adequate assurance has been made, ABC Corp. must provide assurances in a reasonable amount of time. How much time is reasonable will depend on the circumstances, but the UCC does specify that the amount of time cannot exceed 30 days. If ABC Corp. does not provide adequate assurance within a reasonable period of time, XYZ Corp. may treat the contract as having been repudiated, and respond in any of the manners discussed above.
As discussed above, a party to a contract has certain protections if it has reasonable grounds for insecurity regarding the other party’s performance, or if the other party repudiates a contract. Having now examined these protections, in our next article we will move on to a discussion of when a party’s delay or failure to perform may be excused due to force majeure.
Quarles & Brady attorneys Michael Chargo, Hannah Schwartz and Lauren Zenk also contributed to this article.
END NOTES
1 UCC § 2-610; official comment one to UCC § 2-610.
2 UCC § 2-610.
3 Official comment three to UCC § 2-610.
4 UCC § 2-610, UCC § 2-611.
5 UCC § 2-610.
6 Official comment one to UCC S 2-610.
7 UCC § 2-611.
8 UCC § 2-609.
9 UCC § 2-609.
10 See Koursa, Inc. v. manroland, Inc., 971 F. Supp.2d 765 (N.D. Ill 2013); Top of Iowa Co-op. v. Sime Farms, Inc., 608 N.W.2d 454 (Iowa 2000); Puget Sound Energy, Inc. v. Pac. Gas & Elec. Co., 271 B.R. 626 (N.D. Cal. 2002).
11 Official comment three to UCC § 2-609.
