george mason school of law

*George Mason School of Law

Contracts IXVI.Output Contracts and Distributors

F.H. [email protected]

Output and Requirements contracts

UCC 2-306(1) 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.*

Requirements Contracts

Requirements contract: producer agrees to sell as much of his product as buyer requires*

Requirements Contracts

Requirements contract: producer agrees to sell as much of his product as buyer requiresStrategic behavior: misincentives as to quantity*

*Requirements Contracts and Incentives as to Quantity

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

*Requirements Contracts and Incentives

Contract Price > Market PriceMarket Price > Contract PriceSupplier Empire GasEmpire Gas Over-suppliesBuyerAmerican BakeriesAmerican Bakeries under-consumes

Output Contracts

Output contract: buyer agrees to purchase sellers entire output *

Output Contracts

Buyer agrees to buy all of producers outputRisks to buyer:*

Output Contracts

Buyer agrees to buy all of producers outputRisks to buyer:What if market price < contract price*

Output Contracts

Buyer agrees to buy all of producers outputRisks to buyer:What if market price < contract priceWhat if buyer cant use the outputWeak demand for buyers productHigher costs for buyer*

Output Contracts

Buyer agrees to buy all of producers outputRisks to seller:What if market price > contract priceWhat if sellers cost > contract price*

*Price Changes: Output Contracts Assuming that Contract Price > Market Price

Contract Price > Market PriceMarket Price > Contract PriceSupplierBuyer


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


Contract Price > Market PriceMarket Price > Contract PriceSupplierBuyerWants out

*Price Changes: Output Contracts Assuming that Market Price > Contract Price

Contract Price > Market PriceMarket Price > Contract PriceSupplierBuyer

*Price Changes: Output Contracts Assuming that Market Price > Contract Price

Contract Price > Market PriceMarket Price > Contract PriceSupplierWants outBuyer

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

Contract Price > Market PriceMarket Price > Contract PriceSupplierBuyerWoo-hoo!!!!

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

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

*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. 332

*Bakery Levy Distributor Feld Bread crumbs

Output Contracts: Feld v. Levy

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

*


See excerpt on 345*


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 it make sense to require the baker to lose money?Is there something troubling about the numbers?

*


*


What if the baker could sell elsewhere for $1.20Do you think this might do something to his reported costs, if this affords him an out?*


What if the cost of production is now $1.50?*


*


Can a buyer in a requirements contract purchase zero quantities?Posner J. in Empire Gas*


Can a buyer in a requirements contract purchase zero quantities?Empire GasCan a seller in an output contract sell zero quantities?Feld v. Levy*

Output contracts and distributorships

Can resemble each other if the distributor is given the right to sell his clients products*

Exclusive DealingWood v. Duff-Gordon p. 341*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 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 obligation by Wood to use reasonable effortsThe Moorcock: Bowen L.J.: 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 implying duties by the distributor?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 both


UCC 2-205. Every contract imposes upon each party a duty of good faith and fair dealing in its performance and enforcement."


UCC 2-306(2) A lawful agreement by either the seller or the buyer for exclusive dealing in the kind of goods concerned imposes unless otherwise agreed an obligation by the seller to use best efforts to supply the goods and by the buyer to use best efforts to promote their sale.

What are Good Faith Standards

Van Valkenburgh p. 354*

What are Good Faith Standards

Van Valkenburgh p. 354

Just where did the publisher cross the line?*

What is best efforts?*

Bloor v. Falstaff 343

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 cents 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*

Falstaffs history with the Ballantine brandRemedy?

Bloor v. Falstaff*

Falstaff to use best efforts to promote and maintain a high volumeWas this a drafting problem?Or did they get it just right?

Bloor v. Falstaff*

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

Bloor v. Falstaff*

Can you articulate a standard by which best efforts can be judged?What would be excessive?Friendly: Even without the best efforts clause, Falstaff would have been bound to make a good faith effort to see that substantial sales of Ballantine products were made

Bloor v. Falstaff*

Can you articulate a standard by which best efforts can be judged?What would be excessive?Friendly: Profit uber alles was the problem

Bloor v. Falstaff*

Supposing that Falstaff had purchased Ballantine outright. Would profit uber alles have been a problem?

Bloor v. Falstaff*

Supposing that Falstaff had purchased Ballantine outright. Would profit uber alles have been a problem?Lets say that in such a case Falstaff had cut the Ballentine marketing efforts in just the same way

Bloor v. Falstaff*

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

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?Would Ballantine be able to pay Falstaff to do so?

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

*


Real estate agents

Distributorships (Duff Gordon)

*


Real estate agents

Distributorships (Duff Gordon)

PartnershipsOne partners is an agent for his fellow partners*

But the economic definition is broader

Beneficiaries and trustees

*



Shareholders and company directors

*



Shareholders and company directors

Creditors and corporate debtors*


Profit-sharing ventures: Falstaff

*

Agency Costs

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

*

The Agency Cost ProblemAgent misbehaviorUnderperformance by agent retained by principal (shirking, or breach of duties of care)Expropriation of an opportunity (breach of duties of loyalty)

*

Shirking*Of COURSE I can sell your beautiful house!!!

The Agency Cost Problem

How would a principal respond?UnderinvestmentMonitoring of agent

*

The Agency Cost Problem

Agency Costs as the sum of Underperformance by agentsUnderinvestment by principalsMonitoring costs*

Back to Falstaff

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

*

*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 marketing and 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+BallantineJensen and Meckling, 3 J Fin Econ 305 (1976)

Falstaff

What are Ballentines incentives?It gets 50 percent of the revenues and bear none of the marketing costs.So how much would it want spent on marketing?*

Falstaff

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

*

Falstaff

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

*

Falstaff

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

*

Falstaff

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

*

Falstaff

If the goal is optimal joint production, how would you formulate the legal standard?How would you draft Falstaffs duties?best efforts and good faithreasonable best effortsNon-discrimination

*

Responses to Agency Costs?

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


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


Legal standards (e.g., best efforts)Incentivize the parties Relational contracts *


Legal standards (e.g., best efforts)Incentivize the parties Relations ContractsVertical 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 356*Scottsdale Memorial Hospital

Wagenseller 353*The moon is out early tonight

Wagenseller*

Was she fired for reasonable cause?Should that matter?

Wagenseller*

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

Wagenseller*

Was she fired for reasonable cause?The English reasonable cause standard vs. the American at will standardDeveloping exceptions to the at will standardThe public policy exceptionE.g., refusal to commit perjury

Wagenseller*

Was she fired for reasonable cause?The English reasonable cause standard vs. the American at will standardDeveloping exceptions to the at will standardThe public policy exceptionE.g., refusal to commit perjuryDid the employer do an end run around this through a no cause firing?

Wagenseller*

Was she fired for reasonable cause?The English reasonable cause standard vs. the American at will standardDeveloping exceptions to the at will standardImplied in fact promise of tenureAn implied promise to keep the employee on for a period of time

Wagenseller*

Was she fired for reasonable cause?The English reasonable cause standard vs. the American at will standardDeveloping exceptions to the at will standardImplied in fact promise of tenureIs the firms personnel manual part of the contract?Does it matter if this is signed?

Wagenseller*

Was she fired for reasonable cause?The English reasonable cause standard vs. the American at will standardDeveloping exceptions to the at will standardGood faith and fair dealingBad faith firing

Wagenseller*

What standards did the court adopt?Public policyGood faithImplied in fact (employee handbook)

Wagenseller*

Which rule best protects employees?English or American?

Wagenseller*

Which rule best protects employees?Are you sure about that? So why not give them tenure?What are the economic arguments for and against tenure or the English rule?

Sysco at 362*Do the same principles apply in a distributorship agreement?

Sysco*

What did the agreement say about termination rights?

Sysco*

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

Sysco*

Franchisors cannot terminate for bad cause but can do so for no cause

Sysco*

Who were the parties and why did that matter?

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

*


The employee can resign any timeMight the employer be unhappy with this?Labor shortagesFirm-specific assetsTrainingProprietary info

*


The employee can resign any timeCan you think of some way in which the employer might bargain around this?*


The employee can resign any timeCan you think of some way in which the parties might bargain around this?Compensation schemesNon-competes*

Non-competes: Farber at 372*

Freedom of contract governed in Sysco. Why not in Farber?


Freedom of contract governed in Sysco. Why not in Farber?

Who are we protecting by limiting freedom of contract here?


What if we were talking about an accountant?


What if we were talking about an accountant?Cf. Marcam at 379Cf. Maltby at 379


Just what was excessive year, and just how far do you think the employer could go?


How could a severance clause help the employer?


Restatement 187: Covenants in restraint of trade are not enforceable if not ancillary to an otherwise valid agreement?!?


Restatement 187: Covenants in restraint of trade are not enforceable if not ancillary to an otherwise valid agreement?!?Cf Leatherman at 378

*************

george mason school of law

Documents

price changes

sellers cost contract

year contract

output contractsbuyer

output contractscost

actual output

sellers entire output

comparable prior output