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George Mason School of Law Contracts I N. Requirements Contracts F. H. Buckley fbuckley@gmu. George Mason School of Law Contracts I N. Requirements Contracts F. H. Buckley fbuckley@gmu. edu 1

Output and Requirements Contracts: A special case of uncertainty o Vas ist das? n Output and Requirements Contracts: A special case of uncertainty o Vas ist das? n 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. 2

Output and Requirements Contracts o Vas ist das? n Output contract: buyer agrees to Output and Requirements Contracts o Vas ist das? n Output contract: buyer agrees to purchase seller’s entire output 3

Output and Requirements Contracts o Vas ist das? n Output contract: buyer agrees to Output and Requirements Contracts o Vas ist das? n Output contract: buyer agrees to purchase seller’s entire output n Requirements contract: producer agrees to sell as much of his product as buyer requires 4

Output and Requirements Contracts o Why enter into such agreements? 5 Output and Requirements Contracts o Why enter into such agreements? 5

Output and Requirements Contracts o Why enter into such agreements? n Output contract: producer Output and Requirements Contracts o Why enter into such agreements? n Output contract: producer locks in to sale, can safely bulk up on inventory 6

Output and Requirements Contracts o Why enter into such agreements? n Output contract: producer Output and Requirements Contracts o Why enter into such agreements? n Output contract: producer locks in to sale, can safely bulk up on inventory n Requirements contract: buyer assures himself of supply 7

Requirements Contracts o Risks to producer? 8 Requirements Contracts o Risks to producer? 8

Requirements Contracts o Risks to producer n What if market price > contract price Requirements Contracts o Risks to producer n What if market price > contract price n Market @ 120, contract @100 9

Requirements Contracts o Risks to producer: o What if market price > contract price Requirements Contracts o Risks to producer: o What if market price > contract price o What if cost of production > contract price n Cost @120, contract @100 10

Eastern at 317 11 Eastern at 317 11

Eastern o Requirements contract where Gulf was to supply jet fuel to Eastern 12 Eastern o Requirements contract where Gulf was to supply jet fuel to Eastern 12

Eastern o Requirements contract where Gulf was to supply jet fuel to Eastern n Eastern o Requirements contract where Gulf was to supply jet fuel to Eastern n Price adjustment clause : Gulf to pass on 50% of the increase in West Texas Sour 13

So what happened to oil prices in 1974? 14 So what happened to oil prices in 1974? 14

So what happened to oil prices in 1974? 15 So what happened to oil prices in 1974? 15

Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation 16

With predictable results… Gas lines at the pump, 1974 17 With predictable results… Gas lines at the pump, 1974 17

Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation o June 27, 1972: Contract signed 18

Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation o June 27, 1972: Contract signed o Oct. 6, 1973: Yom Kippur War o Oct. 17, 1973: Arab members of OPEC announce an oil embargo on the US o Nov 27, 1973: Emergency Petroleum Allocation Act with two-tier pricing 19

Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation Eastern Air Lines o August 15, 1971: Nixon announces price controls to combat inflation o June 27, 1972: Contract signed o Oct. 6, 1973: Yom Kippur War o Oct. 17, 1973: Arab members of OPEC announce an oil embargo on the US o Nov 27, 1973: Emergency Petroleum Allocation Act with two-tier pricing o With the result that prices went up 20

Requirements Contracts Price fluctuations and Incentives Supplier Buyer 21 Requirements Contracts Price fluctuations and Incentives Supplier Buyer 21

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price Supplier Buyer 22 Supplier wants to sell as much as he can

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price Supplier Buyer 23 Supplier wants to sell as much as he can Buyer wants to buy as little as he can

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price Supplier Buyer 24 Market Price > Contract Price

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price Supplier Buyer 25 Market Price > Contract Price Supplier wants to sell as little as he can

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price > Contract Price Supplier Buyer 26 Supplier wants to sell as little as he can Buyer wants to buy as much as he can

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price > Contract Price Supplier Buyer 27 Gulf wants out Eastern wants to enforce contract

Eastern Air Lines o So why didn’t the price adjustment clause cover the increase? Eastern Air Lines o So why didn’t the price adjustment clause cover the increase? 28

Eastern Air Lines o So why didn’t the price adjustment clause cover the increase? Eastern Air Lines o So why didn’t the price adjustment clause cover the increase? n Based on West Texas Sour (domestic) n 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. 29

Eastern o Wouldn’t it have been simpler to base the price on Gulf’s costs? Eastern o Wouldn’t it have been simpler to base the price on Gulf’s costs? 30

Eastern Air Lines o What is the uncertainty problem? n And how did courts Eastern Air Lines o What is the uncertainty problem? n And how did courts handle it before UCC 2 -306? 31

Eastern Air Lines o What is the uncertainty problem? n And how do courts Eastern Air Lines o What is the uncertainty problem? n And how do courts handle it under UCC 2 -306? o “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” 32

Eastern Air Lines o What is the uncertainty problem? n And how do courts Eastern Air Lines o What is the uncertainty problem? n And how do courts handle it under UCC 2 -306? o “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” o Why is this a criterion of good faith? 33

Eastern Air Lines o How would you approach this as an economic question? 34 Eastern Air Lines o How would you approach this as an economic question? 34

Eastern Air Lines o How would you approach this as an economic question? n Eastern Air Lines o How would you approach this as an economic question? n Who was in the best position to solve the informational problem? 35

Eastern Air Lines Who might have predicted the Yom Kippur War? 36 Eastern Air Lines Who might have predicted the Yom Kippur War? 36

Eastern Air Lines o Suppose you could purchase gas at $1 per gallon. How Eastern Air Lines o Suppose you could purchase gas at $1 per gallon. How much would you want to buy? 37

Eastern Air Lines o Who was behaving opportunistically? n Overinvestment: was Eastern using too Eastern Air Lines o Who was behaving opportunistically? n Overinvestment: was Eastern using too much fuel? 38

Eastern Air Lines o Who was behaving opportunistically? n Overinvestment: was Eastern using too Eastern Air Lines o Who was behaving opportunistically? n Overinvestment: was Eastern using too much fuel? n What is fuel freighting? 39

Eastern Air Lines o Who was behaving opportunistically? n Overinvestment: was Eastern using too Eastern Air Lines o Who was behaving opportunistically? n Overinvestment: was Eastern using too much fuel? n What is fuel freighting? n Gas is $4 a gallon. Your tank is half full. You spot a serve station sell gas at $3 a gallon an you tank up. Problems? 40

Eastern Air Lines o Who was behaving opportunistically? n Undersupply: Was Gulf looking for Eastern Air Lines o Who was behaving opportunistically? n Undersupply: Was Gulf looking for an excuse to get out of the contract? 41

Eastern Air Lines o Who was behaving opportunistically? n Cf. Orange and Rockland at Eastern Air Lines o Who was behaving opportunistically? n Cf. Orange and Rockland at p. 333 42

Eastern Air Lines o Who was behaving opportunistically? n Cf. Orange and Rockland at Eastern Air Lines o Who was behaving opportunistically? n Cf. Orange and Rockland at p. 333 o Buyer increases consumption when gas prices go up, propelling itself to be a large seller of power to other utilities 43

George Mason School of Law Contracts I N. Requirements Contracts F. H. Buckley fbuckley@gmu. George Mason School of Law Contracts I N. Requirements Contracts F. H. Buckley fbuckley@gmu. edu 44

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price > Contract Price Supplier Buyer 45 Supplier wants to sell as little as he can Buyer wants to buy as much as he can

Empire Gas 324 o What was the contract? And why did American Bakeries enter Empire Gas 324 o What was the contract? And why did American Bakeries enter into it? 46

What happened to oil prices in 1979? 47 What happened to oil prices in 1979? 47

Empire Gas o Which explains American Bakeries’ projected switch from gas to propane n Empire Gas o Which explains American Bakeries’ projected switch from gas to propane n To buy propane solely from Empire n For approximately 3, 000 conversion units, more or less depending upon requirements of buyer 48

What happened to oil prices in 1981? 49 What happened to oil prices in 1981? 49

Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Requirements Contracts Price fluctuations and the Incentives of the Parties Contract Price > Market Price > Contract Price Supplier Buyer 50 Gulf wants out Eastern wants to enforce contract

But what if it’s the other way around? Contract Price > Market Price Supplier But what if it’s the other way around? Contract Price > Market Price Supplier Empire Gas Buyer American Bakeries 51 Market Price > Contract Price

But what if it’s the other way around? Contract Price > Market Price Supplier But what if it’s the other way around? Contract Price > Market Price Supplier Empire Gas Buyer American Bakeries 52 Wants to enforce Wants out Market Price > Contract Price

Empire Gas The demand for propane declined as gas prices fell Contract Price > Empire Gas The demand for propane declined as gas prices fell Contract Price > Market Price Supplier Empire Gas Buyer American Bakeries 53 Over-supply Underconsumption Market Price > Contract Price

Empire Gas o What was the contract? n Does the buyer owe good faith Empire Gas o What was the contract? n Does the buyer owe good faith duties not to underconsume? 54

Empire Gas o Posner: If there aren’t any good faith restrictions, that would make Empire Gas o Posner: If there aren’t any good faith restrictions, that would make this an option contract, and requirements contracts are not option contracts 55

Empire Gas o Posner’s good faith duties: n Buyer cancel if a change in Empire Gas o Posner’s good faith duties: n Buyer cancel if a change in his business makes the contract too costly o Southwest Natural Gas at 329 56

Empire Gas o But here: n No reason given by buyer n No change Empire Gas o But here: n No reason given by buyer n No change in fleet of trucks n No business emergency 57

Requirements Contract Price > Market Price Supplier Buyer 58 Wants to enforce: Empire Gas Requirements Contract Price > Market Price Supplier Buyer 58 Wants to enforce: Empire Gas Buyer wants out: Empire Gas Market Price > Contract Price

Requirements Contract Price > Market Price > Contract Price Supplier Buyer 59 Supplier wants Requirements Contract Price > Market Price > Contract Price Supplier Buyer 59 Supplier wants out: Eastern Airlines Wants to enforce: Eastern Airlines

Requirements Contract Price > Market Price Supplier Buyer 60 Wants to enforce: Empire Gas Requirements Contract Price > Market Price Supplier Buyer 60 Wants to enforce: Empire Gas Buyer wants out: Empire Gas Market Price > Contract Price Supplier wants out: Eastern Airlines Wants to enforce: Eastern Airlines