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“Course of Dealing and Contracts”

Middle Market Legal Toolbox Blog Kevin Slaughter

A manufacturing client (“Client”) recently came to us with a common problem: it was losing money in a long-standing supply agreement with Buyer, which had two years left to run and guaranteed pricing for another six months. Client’s production lead times had increased dramatically since the last negotiation of terms, and the agreement required Client to maintain significant safety inventory for the benefit of Buyer. However, despite repeated requests by Client, Buyer had failed to provide purchase forecasts for some time, and there was concern that Buyer would not continue to purchase all of the product produced by Client as it had previously. Seeing only darkness at the end of the tunnel, Client desired to reject all future purchase orders unless the Buyer agreed to compromise on price and lead times.

Attempting to change contractual terms through an exercise of discretion granted under a contract—such as rejecting purchase orders—is generally not good practice. Parties to a contract are bound not only by the contract’s express terms but also by the implied duties of good faith and fair dealing. That means, especially in a long-term contract like this one, that the parties’ past practices are highly relevant in determining the propriety of discretionary action under the contract. A flat refusal to honor future purchase orders, without an appropriate and valid business reason, could easily open Client up to breach-of-contract claims. Indeed, if a court were to find that a party effected a “termination” of the contract through such discretion, the claims could be even worse. Moreover, because Client had agreed to a guaranteed pricing schedule and to hold certain quantities of inventory, it could not justify a refusal on pricing or lead times alone.

Robert Lusch and James Brown note in ” Interdependency Contracting and Relational Behavior in Marketing Channels” that businesses often find it unnecessary to use legal sanctions where relational norms govern acceptable behavior among exchange partners, and that the misuse of contracts can actually create irreconcilable conflict and other dysfunctional behavior.

It may seem like Client is between a rock and a hard place—losing money on the contract and struggling (or even failing) to meet supply deadlines due to the Buyer’s insouciance in submitting forecasts. While it is certainly not an enviable position, there are certain proactive steps Client can take that may help it to extricate itself:

  • Past practices is the lodestar – Client should gather (or, if necessary, begin to document) as much data as possible on prior purchase orders, including lead time, delivery dates, pricing, whether terms were changed or orders cancelled, etc. Client should especially focus on those instances, large or small, where Buyer has violated either the letter or spirit of the agreement—everything that has been “hard to live with” in the relationship;
  • Client should gather all information that demonstrates the detriment these Buyer “bad acts” have caused the Client;
  • Moving forward, Client should scrutinize every purchase order—those that fall outside of past practices can likely be rejected;
  • Client should consider a demand for adequate assurance from Buyer, covering any area where Buyer has failed to comply with the agreement; this demand must comply with the UCC. If Buyer fails to provide the assurance, Client will have its own breach of contract claim.

By gathering an arsenal of data on past behavior, Client can make informed discretionary decisions moving forward.