1 George Mason School of Law Contracts II Relational Contracts III F.H. Buckley [email protected]

*George Mason School of Law

Contracts II

Relational Contracts III

F.H. [email protected]

Output and Requirement Contracts

Vas ist das?*


Vas ist das?Output contract: producer agrees to sell his entire output to buyer

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Vas ist das?Output contract: producer agrees to sell his entire output to buyerRequirements contract: producer agrees to sell as much of his product as buyer requires*


Why enter into such agreements?Output contract: producer locks in to sale, can safely bulk up on inventory

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Why enter into such agreements?Output contract: producer locks in to sale, can safely bulk up on inventoryRequirements contract: buyer assures himself of supply*


Recognized in UCC 2-306Otherwise an indefiniteness problem*

What happened in Eastern?*

Eastern

Requirements contract where Gulf was to supply jet fuel*

So what happened to oil prices in 1974?*

Eastern Air Lines

August 15, 1971: Nixon announces price controls to combat inflationJune 27, 1972: Contract signedOct. 6, 1973: Yom Kippur WarOct. 17, 1973: Arab members of OPEC announce an oil embargo on the US after the Yom Kippur WareNov 27, 1973: Emergency Petroleum Allocation Act

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With predictable results*Gas lines at the pump, 1974

Eastern Air Lines

So why didnt the price adjustment clause cover the increase?

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Eastern Air Lines

So why didnt the price adjustment clause cover the increase?Based on West Texas Sour (domestic)The Nixon administration imposed price controls, fixing the price of old oil and permitting higher prices only to the extent that new oil was produced.

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Eastern

Why didnt they base the price on Gulfs costs?*

Eastern Air Lines

UCC 2-306: good faith duties: were they implicated?*

Eastern Air Lines

UCC 2-306: good faith duties: were they implicated?Does good faith imply a price based on market or West Texas Sour?Do abnormal price increases go to good faith?*

Eastern Air Lines

UCC 2-306: good faith duties: were they implicated?Does good faith imply a price based on market or West Texas Sour?Was the contract meant to cover such price increases?*

Eastern Air Lines

How would you approach this as an economic question?*

Eastern Air Lines

How would you approach this as an economic question?Who was in the best position to solve the informational problem?*

Eastern Air Lines*Who predicted the Yom Kippur War?

Eastern

How was Easterns fuel freighting relevant? *

Eastern

How was Easterns fuel freighting relevant?A breach of good faith or standard industry practice? *

Eastern

How was Easterns fuel freighting relevant?A breach of good faith or standard industry practice?Suppose Eastern had started to sell jet fuel to other airlines? *

*Requirements ContractsPrice fluctuations and Incentives

SupplierBuyer

*Requirements ContractsPrice fluctuations and the Incentives of the Parties

Contract Price > Market PriceSupplierBuyer


Contract Price > Market PriceSupplierSupplier wants to sell as much as he canBuyer


Contract Price > Market PriceSupplierSupplier wants to sell as much as he canBuyerBuyer wants to buy as little as he canand its buyers option


Contract Price > Market PriceMarket Price > Contract PriceSupplierBuyer


Contract Price > Market PriceMarket Price > Contract PriceSupplierSupplier wants to sell as little as he canBuyer


Contract Price > Market PriceMarket Price > Contract PriceSupplierSupplier wants to sell as little as he canBuyerBuyer wants to buy as much as he canand its buyers option


Contract Price > Market PriceMarket Price > Contract PriceSupplierSupplier wants to sell as much as he canSupplier wants to sell as little as he canBuyerBuyer wants to buy as little as he canBuyer wants to buy as much as he can

Eastern Air Lines

Suppose you could purchase gas at $1 per gallon. How much would you want to buy?*

Eastern Air Lines

Suppose you could purchase gas at $1 per gallon, but were not permitted to resell it.Would this change your driving habits?*


Contract Price > Market PriceMarket Price > Contract PriceSupplier

Buyer



BuyerOver-consumption


Contract Price > Market PriceMarket Price > Contract PriceSupplierUnder-supplyBuyer


Contract Price > Market PriceMarket Price > Contract PriceSupplierOver-supplyBuyer


Contract Price > Market PriceMarket Price > Contract PriceSupplierBuyerUnder-consumption


Contract Price > Market PriceMarket Price > Contract PriceSupplierOver-supplyUnder-supplyBuyerUnder-consumptionOver-consumption

*Requirements ContractsPrice fluctuations and the Incentives of the Parties UCC 2-306 (1): no quantity unreasonably disproportionate to any stated estimate


Contract Price > Market PriceMarket Price > Contract PriceSupplierGulf under-suppliesBuyerEastern Air Lines over-consumes

Eastern Air Lines

Who was behaving opportunistically?Overinvestment: was Eastern using too much fuel?

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Eastern Air Lines

Who was behaving opportunistically?Undersupply: Was Gulf looking for an excuse to get out of the contract?

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Eastern Air Lines

Who was behaving opportunistically?Cf. Orange and Rockland at p. 330

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Eastern Air Lines

Who was behaving opportunistically?Cf. Orange and Rockland at p. 330Buyer increases consumption when gas prices go up, propelling itself to be a large seller of power to other utilities

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Empire Gas 320

What was the contract?*

Empire Gas

What was the contract?To buy propane solely from EmpireFor approximately 3,000 conversion unites, more or less depending upon requirements of buyer*

Empire Gas

What was the contract?Is the only purpose of the contract to provide the buyer with assurance of supply?*

Empire Gas

What was the contract?Are there any restrictions on a buyers under-consumption on a requirements contract?*

Empire Gas

What was the contract?Are there any restrictions on a buyers under-consumption on a requirements contract?Posner: That would make this an option contract, and requirements contracts are not option contracts

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Empire Gas

Posners good faith duties: Buyer can cancel if a change in his business makes the contract too costlySouthwest Natural Gas*

Empire Gas

Posners good faith duties: Buyer can cancel if a change in his business makes the contract too costlySouthwest Natural GasBuyer cant cancel because he has found a cheaper supplier

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Empire Gas

Posners good faith duties: Buyer can cancel if a change in his business makes the contract too costlySouthwest Natural GasBuyer cant cancel because he has found a cheaper suppliermore than whim is required*

Empire Gas

Here:No reason given by buyerNo change in fleet of trucksNo business emergency

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*George Mason School of Law

Contracts II

Relational Contracts III

F.H. [email protected]

Next day

II. The Terms of the Contract*

Last day: Requirement Contracts

Producer agrees to sell as much of his product as buyer requiresOffers manufacturer security as to partsEg, GM Fisher *

*Requirements Contracts


BuyerBuyer wants to increase purchases: Eastern Airlines

*Requirements ContractsPrice fluctuations and the Incentives of the Parties UCC 2-306 (1): no quantity unreasonably disproportionate to any stated estimate

Output Contracts

Producer agrees to sell his entire output to buyer

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Output Contracts

Vas ist das?Output contract: producer agrees to sell his entire output to buyerWhich offers him security as to sales

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Output Contracts

Producer agrees to sell his entire output to buyerRisks:What if market price > contract priceWhat if cost of production > contract price*

*Price Changes: Output Contracts Assuming that Cost < Contract Price

Contract Price > Market PriceMarket Price > Contract PriceSupplierBuyer


Contract Price > Market PriceMarket Price > Contract PriceSupplierWoo-hoo!!!!Buyer


Contract Price > Market PriceMarket Price > Contract PriceSupplierWoo-hoo!!!!BuyerWants out


Contract Price > Market PriceMarket Price > Contract PriceSupplierWoo-hoo!!!!Wants outBuyerWants out


Contract Price > Market PriceMarket Price > Contract PriceSupplierWoo-hoo!!!!Wants outBuyerWants outWoo-hoo!!!!

*Can the supplier opt out if the market price changes?

Contract Price > Market PriceMarket Price > Contract PriceSupplierWants outBuyer

*UCC 2-306: Would Empire gas apply?

Contract Price > Market PriceMarket Price > Contract PriceSupplierWants outBuyer

*What if Sellers Costs Increase?

Contract Price > CostCost > Contract PriceSupplierBuyer

*Output ContractsCost to Seller

Contract Price > CostCost > Contract PriceSupplierWants outBuyer

Output Contracts: Feld v. Levy p. 329

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Output Contracts: Feld v. Levy p. 329

A renewable one-year contract in which Levy agrees to sell all its bread crumbs to FeldLevy discovers that the marginal cost ($1.06) exceeds the contract price ($1.00) and cancels

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Output Contracts: Feld v. Levy

Held: It would be bad faith for Levy to stop crumb production just because their profits aren't as high as they expected, but it would be good faith for Levy to stop crumb production if they incurred losses from such production that were "more than trivial". *


Does this make sense?Would you want to know more facts?

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Does this make sense?What if there are other suppliers of bread crumbs?

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Does this make sense?What if there are other suppliers of bread crumbs?Can you imagine how the buyer might bargain strategically?

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Does this make sense?What if market price is now $1.50?Now the seller wants out: can it shut down production?*

Exclusive DealingWood v. Duff-Gordon p. 338*Lady Duff Gordon

Exclusive DealingWood v. Duff-Gordon*

Wood to have the exclusive right to market her clothes or endorsementsIn return to receive one-half of all profits and revenuesOne year term, renewable unless cancelled on 90 days notice


Is this a binding contract?Is it too uncertain?


Is this a binding contract?Is it too uncertain?Does it lack consideration?


Is this a binding contract?Cardozo: an instinct with an obligationThe Moorcock: imply a term to give business efficacy to an agreement


What is the economic rationale for finding a binding contract here?


What is the economic rationale for finding a binding contract here?Consider Woods incentive to make contract-specific investments


How would you formulate the duties of the parties, as a matter of legal drafting?


How would you formulate the duties of the parties, as a matter of legal drafting?Good faith by Duff-GordonBest efforts by Wood

Good Faith Standards

Van Valkenburgh p. 351*

Best efforts clauses

The parties can avoid Duff Gordon problems by stipulating for best efforts by a distributor*

Best efforts clauses

The parties can avoid Duff Gordon problems by stipulating for best efforts by a distributorUCC 2-306(2)*

Bloor v. Falstaff*

Bloor v. Falstaff*What was the deal?

Bloor v. Falstaff*Falstaff buys all Ballantine assets except the brewery for $4M plus a royalty of 50 cent on each barrel of Ballantine soldBuyer to use best efforts to promote and maintain a high volume of salesBuyer to pay $1.1M per year if it substantially discontinues selling Ballantine

Bloor v. Falstaff*

Falstaffs history with the Ballantine brand

Bloor v. Falstaff*

Falstaffs history with the Ballantine brandBrieant: nonfeasances and misfeasancesFalstaff stressed profit at the expense of volumeFalstaff simply didnt care about Ballantines volumeFalstaff put more effort into the Falstaff brand

Bloor v. Falstaff*

Falstaff to use best efforts to promote and maintain a high volumeWas this a drafting problem?How would you have drafted it?

Bloor v. Falstaff*

Can you articulate a standard by which best efforts can be judged?What would be excessive?

Bloor v. Falstaff*

Would you expect that the parties would bargain for sales efforts that would exceed what Falstaff would expend had it a 100 % equity stake in the Ballantine brand?

Bloor v. Falstaff*

An agency cost problem

Agency: Common Law*

Legal relationship whereby a principal, expressly or impliedly, authorizes an agent to create a legal relationship between the principal and a third party

Agency: An economic concept*

Any relationship in which a principal, expressly or impliedly, authorizes an agent to confer benefits or impose costs on the principal

The two definitions may overlap

Real estate agents

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Real estate agents

Distributorships (Duff Gordon)

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Real estate agents

Distributorships (Duff Gordon)

PartnershipsOne partners is an agent for his fellow partners*

But the economic definition is broader

Beneficiaries and trustees

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Shareholders and company directors

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Shareholders and company directors

Bankers and company directors*


Profit-sharing ventures: Falstaff

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Agency Costs

Because the incentives of agents are not perfectly aligned with those of his principal, the agent may impose costs on him.

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Back to Falstaff

The agent (Falstaff) has to decide how much money to spend on marketing the principals (Ballantine) beer

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*Agency CostsHow much Ballantine beer to sell?Quantity of beer$Horizontal axis measures the quantity of beer sold

*Agency Costs$Marginal RevenueAssume a constant amount of revenue for each case of Ballantine beer sold

*Agency Costs$Marginal RevenueMarginal Cost of MarketingFalstaff has to spend an increasing amounton marketing for additional units of beer sold

*Agency Costs$Marginal RevenueMarginal Cost of MarketingXOptimal sales at Quantity X

*At X* Falstaff can profitably spend more on marketing$Marginal RevenueMarginal Cost of MarketingXX*

*At X~ Falstaff can profitably reduce marketing expenditures$Marginal RevenueMarginal Cost of MarketingXX~

*Now what happens when revenues are shared with an agent?$Marginal RevenueMarginal Cost of MarketingX

*The principals marginal revenue curve is lowered$MRFalstaff+BallantineMarginal Cost of MarketingXMRFalstaffThe $0.50 tax

*So that Falstaff has an incentive to reduce marketing expenditures$Marginal Cost of MarketingXMRFalstaffX*MRFalstaff+Ballantine

An Application*

Falstaff

Neither Falstaff nor Ballantine had perfect incentives

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Falstaff

Neither Falstaff nor Ballantine had perfect incentivesBallantine bears zero marketing costs and would want Falstaff to spend excessively on marketing

*

*So that Falstaff has an incentive to reduce marketing expenditures$Marginal Cost of MarketingXMRFalstaffX*MRFalstaff+Ballantine

Falstaff

Neither Falstaff nor Ballantine had perfect incentivesBallantine has an incentive to spend too much and Falstaff too little.

*

Falstaff

Neither Falstaff nor Ballantine had perfect incentivesBallantine has an incentive to spend too much and Falstaff too little.If its a question of optimal joint production, its no answer that Falstaff was simply looking to the Falstaff bottom line

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Falstaff

If the goal is optimal joint production, how would you formulate the legal standard?

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Falstaff

If the goal is optimal joint production, how would you formulate the legal standard?Did the court get it right?

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Falstaff

If the goal is optimal joint production, how would you formulate the legal standard?How would you draft Falstaffs duties?

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Falstaff

If the goal is optimal joint production, how would you formulate the legal standard?How would you draft Falstaffs duties?best effortsreasonable best effortsNon-discriminationGood faith

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Responses to Agency Costs?

Legal standards (e.g., best efforts)*


Legal standards (e.g., best efforts)Incentivize the parties Cost-sharingProfit-sharingSliding scale*


Legal standards (e.g., best efforts)Incentivize the parties Relations and Iterated PD Games*


Legal standards (e.g., best efforts)Incentivize the parties Relations and Iterated PD GamesVertical Integration*

*Post-contractual opportunism

But see R.H. Coase, The Acquisition of Fisher Body by General Motors, 43 J.L.E. 15 (2000)*

*Optimal Firm SizeCoase, The Nature of the Firm, 16 Economica 386 (1937) People organize production within firms to economize on transaction costs (and opportunism costs) of private contracting

*Optimal Firm SizeCoase, The Nature of the Firm, 16 Economica 386 (1937) People organize production within firms to economize on transaction costs (and opportunism costs) of private contracting

People organize production by private contracting to benefit from informational gains which are lost when production is brought within a firm

Optimal Firm SizeFirms might then be too small (GM) or too large (conglomerization)*


Legal standards (e.g., best efforts)Incentivize the parties Relations and Iterated PD GamesVertical IntegrationMonitoring plus termination rights*

Wagenseller*The moon is out early tonight

Wagenseller*

Was she fired for reasonable cause?The English standard vs. the American at will standard

Wagenseller*

Was she fired for reasonable cause?Should that matter?

Wagenseller*

Was she fired for reasonable cause?What if the employer had fired her for bad cause?

Wagenseller*

Was she fired for reasonable cause?What if the employer had fired her for bad cause?Should the public policy exception have been triggered?

Wagenseller*

Was she fired for reasonable cause?What if the employer had fired her for bad cause?Should the public policy exception have been triggered?Did the employer do an end run around it?

Wagenseller*

Which rule best protects employees?English or American?

Wagenseller*

What about not following the employee handbook?

Wagenseller*

Which rule best protects employees?Are you sure about that? So why not give them tenure?

Wagenseller*

Which rule best protects employees?Are you sure about that? So why not give them tenure?How often do parties bargain around it?

Wagenseller*

Which rule best protects employees?Are you sure about that? So why not give them tenure?Can you think of an argument for tenure in the academic world?

Sysco*

You have to terminate a franchisee. How do you do it?

Sysco*

Franchisors cannot terminate for bad cause

Sysco*

But the lack of good cause does not amount to a bad cause termination

Sysco*

Mums the word

Note the two-way play

The employer has a free hand to dismiss the employee under the at-will standard

The employee can resign any time

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Note the two-way play

The employer has a free hand to dismiss the employee under the at-will standard

The employee can resign any timeBut can the employer fetter the employee with a non-compete?

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Documents

1 George Mason School of Law Contracts II Relational Contracts III F.H. Buckley [email protected]